Don’t Bet Either Way On Market Volatility

With VIX spiking, it’s tempting to pile in or bet against it. Both are a bad idea.

I’ve written extensively about the volatility exchange-traded products, like the iPath S&P VIX Short-Term Futures ETN (VXX | A-47) and the C-Tracks Citi Volatility ETN (CVOL | D-49). I’ve written about how you have to have perfect timing for investments in these VIX futures products to work. I’ve written about the hows and whys of the triple-digit run in the VelocityShares Daily Inverse VIX Short Term ETN (XIV).

My deep skepticism for these products sets my email box on fire when we have a two-week period like the last two weeks. We had our first little downdraft in the S&P 500 for a while, and the volatility lovers went nuts.

Just as VIX proponents expect, when the S&P 500 dropped a few percent in a few days, the level of the CBOE Volatility Index spiked enormously. In fact, at one point it was nearly double where it was just this spring. Surely you made tons of money by being hedged with a volatility ETP, right?

Well, sort of.

Using the same six-month window, yes, your volatility investment went up during the worst of the last few weeks, but on a total return basis, you were still way out of the money.

The best performers overall were products focused on the midterm area of the curve, like the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ | B-37), that try to mitigate the contango in the VIX futures market by not holding the front-month.

The worst performer was CVOL, which not only owns midterm VIX futures, but takes a 2.5x short on the S&P 500 (most of the time, depending on a model).

Of course, as always, if your timing was perfect, you made a killing.

If you bought right at the end of September, fearing a classic October rundown in the S&P 500, and you just happened to sell at the peak of the panic, you could have made 42 percent on your CVOL position, or 26 percent in VXX.

Both were vastly behind the actual 61 percent spike in VIX, but still that sounds pretty awesome if your S&P 500 position was down 5.5 percent. The problem, of course, is that rarely is your timing that perfect.

But what about the other end of the trade? After all, the inverse product to VXX—XIV—got hammered during the volatility spike, just like you’d expect. Doesn’t that make it the perfect time to buy in?

The irony here is that using year-to-date performance, it turns out both XIV and VXX returned the exact same amount—down about 14 percent, creating one of those cruel ironies of investing. How is that passible?

Well, XIV can’t be a “pure” negative of VXX, because like almost all inverse funds, it rebalances daily, so that each day, it will provide negative 100 percent exposure to its index, without any unexpected compounding.

Over the very long term, XIV has still been enormously successful, because the contango in the VIX futures market has acted as a tail wind, overwhelming the rebalancing effect and its own expense ratio.

So why not plow into XIV now? After all, with the recent spike in volatility, you can buy in when volatility is high (and nearly guaranteed to reset back to long-term averages).

The problem is the futures curve. The entire reason XIV has been successful is that it’s been able to profit from the very same crippling contango that’s bankrupted VXX holders since XIV launched in 2010, taking away $95 from every $100 invested.

And that contango is gone for the moment. Here’s the futures curve for VIX right now:

The current curve is the one on the top right—note how it goes down for the first few months? That’s backwardation. VXX and other front month-products will actually benefit from this on the roll. Just one month ago, the curve was contango hell—that orange line in the lower right. And that, long term, is what you’d expect the curve to continue to be.

That’s what it looked like a year ago (the left-hand fuchsia line), and that’s what I’d expect it to look like again soon. Anytime spot VIX spikes dramatically, it has a tendency to pull the front of the curve up into backwardation.

But I’m pretty positive it will be temporary, as it pretty much always has been.

For that to happen, volatility will have to drop, while the futures contracts stay expensive, or the futures contracts will have to go higher. Neither one is the “free lunch” scenario XIV investors are counting on.

So right now, in my opinion, you’re in a no-win situation. I think volatility will slowly return to normal, and neither the long- nor the short-term VIX products are particularly going to benefit until the term structure returns to normal.

Obviously, if VIX collapses, an XIV bet would pay off, but not with the kind of insurance a steeply contangoed curve would suggest.

At the time of this writing, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.