Update February 2018: Credit Suisse will shut down this fund after the heavy losses on February 5:
I was hoping to tell you about a great new investment I researched recently. It’s an ETN (ETN=Exchange-Traded Note, similar but not identical to an Exchange-Trades Fund) with a phenomenal track record; year-to-date (as of October 20 when writing this) it’s up 141%! Since inception (November 30, 2010) it’s up by 1,079%, over 40% annualized compound return! But, as you can see from the title, I’m still skeptical!
Why do I even look at some exotic ETN/ETF? Aren’t we all supposed to be index investors? Buy your VTSAX and be done? Nope! I consider myself an index investor with an open mind. It’s very hard to outperform the index by picking individual stocks, but there are many other ways to deviate from index investing. For example, I like real estate investing and options trading. In both cases, it’s not really about beating the VTSAX but I like the return profiles and the diversification benefits.
So, back to that amazing ETN. The ticker is XIV and here’s the cumulative return chart since 2010. $100 would have grown to almost $1,200!
That looks like a pretty impressive run. It definitely got my attention! But after doing some more detailed analysis I realized this ETN is not for me. At least not right now. But what’s not to love about 1,000% return since 2010, when the S&P500 returned “only” 150% since then? That’s the topic of today’s blog post…
How does the XIV work?
As the name cleverly suggests, XIV is the inverse-VIX, so the ETN is shorting the VIX. You can do that by (short-)selling VIX futures. Just a quick reminder: what’s the VIX? There is an intuitive and a technical explanation:
- Intuitively, the VIX is called the “Fear Index” because it measures how much fear and risk aversion investors currently have. During tranquil times this fear gauge is around 12-15. Currently, it’s even below that at around 10 to 11, but during stress periods (e.g. Global Financial Crisis) it can jump all the way up into the 80s.
- Technically, the VIX is derived from options prices on the S&P500 stock index. It’s the average implied volatility on index options, measured as the annualized standard deviation. I could provide more technical details but I don’t want to put y’all to sleep.
Why is “shorting the VIX” so profitable?
Short-selling an asset is a bet on the value going down. You sell something at a high price and hope to buy it back in the future at a lower price. Shorting the VIX is also a bet on equities doing well, because of the inverse relationship between volatility and equity prices; volatility goes down when the market goes up and everybody is optimistic. And vice versa, volatility goes up when the market goes down and investors become nervous.
Here’s one quirk that makes this VIX selling so appealing: The short VIX strategy makes money even if the VIX moves sideways! How amazing is that?! That’s because (most of the time, at least) the price of the VIX Futures contract with an expiration weeks or months in the future is substantially higher than today’s VIX level. Finance wonks would say that the “VIX term structure is in contango.” For example, on October 20, I checked the quotes: The VIX on that day closed at 9.97, but the Futures contract expiring on November 15 was trading at 11.32. $1.35 higher! Each contract has a multiplier of 1,000, so you’d make $1,350 in 26 days. Considering that I’d need about $30,000 in margin cash to short that contract, that’s a return of 4.50% if the VIX were to stay at 9.97 until November 15. 4.5% in 26 days translates into an annualized compound return of 86%! Pretty nice passive income! And if the VIX were to go down the return would be even higher, which is how we can get returns of 100% and more!
So, the great allure of this VIX strategy is that the VIX has to do absolutely nothing and we’d still make money. Lots of it! Even if the VIX were to go up slightly to, say, 10.50 or 11, we’d still make a decent return. As we all know, investing in stocks can be really frustrating at times: they occasionally move sideways and we make nothing (maybe 2% dividend yield) but this VIX strategy makes 5% monthly return or more if nothing happens! How cool is that?
What can go wrong with shorting the VIX?
Glad you asked! Very simple: when the VIX rises substantially. All it takes is some crazy talk from “Rocket Man,” a few bad earnings reports, a failure of the tax reform plans in Congress, and the VIX can easily end up way above 11.32. You’d wipe out several months’ (or years’!) worth of income potential! As we will see below, this has happened more than once since 2010. (update 10/25/2017: The VIX has actually risen slightly and the ETN has dropped by more than 5% since the Friday close!)
Why I don’t like this ETN:
Here are the main reasons why I will not invest in this ETN, despite the impressive past performance:
- Risk-adjusted returns are actually inferior to just the plain old S&P500!
- Lack of diversification benefits.
- Drawdown periods were brutal.
- Uncertainty about the tax treatment.
Let’s look at the issues in detail:
1: Extreme leverage: the fund behaves like an equity portfolio with 4.5x (!) leverage
Anytime I see a strategy or an ETF/ETN that supposedly outperformed the broad index I ask myself, where does this outperformance come from? You see, I can very easily outperform the S&P500 benchmark if I simply lever it up by a factor of 1.2x or 1.5x. I take more risk and get more return (on average and over a long enough time span). That doesn’t that make me a smarter investor! So, the measures I look at to check if your outperformance is simply leverage in disguise:
- The Sharpe Ratio: It measures how much excess return (over a safe, cash/money-market return) I generate, per unit of risk. According to this measure, the XIV had a pretty lackluster performance: A Sharpe Ratio of 0.649, worse than the S&P500 (see table below), despite the amazing 40%+ annualized return. That’s because the volatility was six times the S&P’s! If the return is only 3 times the S&P’s then the risk-adjusted return of the XIV doesn’t look so attractive anymore.
- The Equity Beta: A similar idea, but a slightly different calculation. Run a simple linear regression of XIV returns on SPY returns. The slope is 4.56, so the XIV behaves like a 4.56x leveraged equity portfolio. No wonder the average return and volatility are so high. But I have to ask myself, do I really want to invest in an asset that’s like an equity portfolio on steroids? It works well in a bull market, but what happens when the bull market comes to an end?
- The Alpha vis-a-vis the S&P500: The XIV ETN trails the performance of a 4.5x leverage equity portfolio by about 0.60% per month! So even if I wanted to have a portfolio with equity on steroids, I could do that a lot better by simply using equity futures with 4.5x leverage and outperforming this XIV ETN by 0.6% per month, over 7% per year!
2: Lack of diversification benefits
OK, so on a stand-alone basis, this ETN doesn’t look appealing. Who wants to have a portfolio with 60%+ annualized volatility? But that doesn’t mean this is a bad asset. Maybe this ETN helps in the overall portfolio context. Maybe there are some diversification benefits when adding this ETN to a good old Stock/Bond Portfolio!
The way I normally test for diversification benefits is to draw two efficient frontiers; one with just a plain stock/bond portfolio and one with the new asset. Does the efficient frontier move and by how much? Well, it turns out the addition of the XIV doesn’t improve the efficient frontier at all! Let’s look at the chart below. XIV obviously extends the efficient frontier (see the black line connecting the SPY and the XIV), but it doesn’t move the efficient frontier to the left of the green line (stock-bond-only efficient frontier). If that’s hard to see I also include a second chart where I zoom in a bit more. This means that if I target risk levels below a 100% equity portfolio (say, a 90/10 or 80/20 portfolio), the optimal portfolio would include no XIV allocation.
But it gets even worse; even if you are OK with a higher risk level than a 100% equity portfolio, you could have done better by simply leveraging up equities (magenta line is to the left of the black line North of the SPY point) or, even better, you could have leveraged the tangency point (i.e., highest Sharpe Ratio portfolio) and moved even further to the left (see cyan line)! So, XIV is a real catch-22: useless in a low-risk portfolio, and dominated by leveraged portfolios for high-risk-target portfolios!
3: The drawdowns have been brutal
Let’s compare how much this ETN would have lost during some of the peak-to-bottom moves. Both in 2011 and 2015 the fund lost around 70% of its value, see chart below. The worst drawdown of -74% peak to bottom occurred in 2011. If you ask the average person what happened in 2011 they probably wouldn’t even remember. It was the downgrade of the U.S. Treasury Bond rating by the credit rating agencies and the concern that the U.S. might not be able to service its debt and principal payments after discussions about the debt ceiling in Congress failed. Of course, in the big scheme, this was a tiny blip in the roaring 2009-2017 equity bull market. If such a small blip in 2011 caused such massive losses what would happen if in the next real market event, the next recession? This ETN is untested in those environments!
Update February 2018: Well, it was tested on February 5 and it didn’t look pretty. See chart at the top of this page: -96% since the peak in January! The fund will shut down later this month!
4: Tax treatment
Another unpleasant surprise when buying this fund in a taxable account: according to the prospectus:
It is also possible that the IRS would seek to characterize your ETNs as regulated futures contracts or options that may be subject to the provisions of Code section 1256. In such case, the ETNs would be marked to market at the end of each taxable year and 40% of any gain or loss would be treated as short-term capital gain or loss, and the remaining 60% of any gain or loss would be treated as long-term capital gain or loss.
It’s not confirmed that this is how the IRS will actually treat this ETN, but be aware of this tax limbo if you want to invest! But if the IRS decides the XIV profits are taxed under Section 1256, all gains along the way might be taxed at 60% long-term and 40% short-term capital gains. Every year! There is no deferring the capital gains until you sell the ETN!
When this fund might be a good idea
Do I have only bad things to say? Well, there can be at least two occasions when it makes sense to look into this inverse-VIX ETN:
- You want to gain leverage in a retirement account. Buying anything on margin in a retirement account is somewhere between impossible and very cumbersome so this ETN with a lot of equity leverage in disguise might be a nice way to juice up returns.
- We see another volatility spike. This ETN has seen 70%+ drops even during a moderate market event outside of a recession, e.g., 2011 and 2015. But after each precipitous drop, it came roaring back again. So, if we see a similar drop again and a rise of the VIX to at least 30, I will definitely revisit this strategy!
Even though I work in the finance industry (or maybe because I work there???), I’m very suspicious about some of the financial innovations thrown out at the retail market. But I’m also a pretty open-minded investor, so my criticism here is not because I’m a dogmatic index investor trash-talking everything outside my comfort zone. The risk/return profile of this fund simply doesn’t look all that attractive to me. 40% annualized returns isn’t so hot anymore when I face 60%+ annualized risk and 70%+ losses peak to bottom!
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