This fund returned over 100% year-to-date. I’m still not buying it!

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!

XIVstudy Chart02
XIV (inverse VIX ETN) and SPY (S&P500 index ETF) returns. 11/30/2010=100.

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.
XIVstudy Chart05
CBOE VIX Index.

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!

XIVstudy Chart01
VIX Futures Term Structure snapshot on October 20: You can sell the November 15 Future at 11.32, even though current VIX is only 9.97. If the VIX stays the same you’d make $1.35!

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:

  1. Risk-adjusted returns are actually inferior to just the plain old S&P500!
  2. Lack of diversification benefits.
  3. Drawdown periods were brutal.
  4. 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:

  1. 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.
  2. 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?
  3. 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!
XIVstudy Table01
Return Stats: Based on monthly returns Nov 30, 2010, to Sep 30, 2017. SPY=S&P500 index ETF, IEF=7-10Y U.S. Treasury Bond ETF, Cash=3M T-bill returns.

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.

XIVstudy Chart03
Efficient Frontier Analysis, based on realized returns 11/2010-09/2017. Adding the XIV does not improve the efficient frontier. The Stock/Bond-only efficient frontier is right on top of the IEF/SPY/XIV Efficient Frontier. The portions of the Efficient frontier that do use the XIV are dominated by a simple leveraged SPY portfolio (magenta line) and even more so by leveraging the maximum Sharpe Ratio portfolio (cyan line).
XIVstudy Chart03_zoom
Same Efficient Frontier CHart, but zoomed in: XIV doesn’t offer any diversification benefits: The Stock/Bond-Only frontier is right on top of the unconstrained efficient frontier.

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!

XIVstudy Chart04
Drawdown from peak (based on daily data). SPY (S&P500 ETF) and XIV (Inverse VIX ETN). 11/30/2010 to 10/20/2017

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:

  1. 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.
  2. 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!

Conclusion

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!

We hope you enjoyed today’s post! Please share your thoughts and comments below!

 

 

 

 

Advertisements

32 thoughts on “This fund returned over 100% year-to-date. I’m still not buying it!

  1. Another fantastic, insightful article, Big ERN.

    With respect to your important work in the realm of near & early post-retirement glide path and risk reduction, I am wondering if you have thought of delving into the potential value of the following within a (soon to be) early retirees portfolio: a) covered options selling, and b) shorting (similar to Peter’s question) of highly positively correlated, high beta funds?

    Thanks for all you do!

    Liked by 1 person

    • Excellent point! My personal experience is that in terms of risk-adjusted returns Short-Put > S&P500 index > Short-VIX. And all are highly correlated! So it looks like doing the short-put strategy while going long(!!!) the VIX as a hedge may not be a bad idea! Or maybe go long the VIX when the VIX-spot is low (e.g. below 12) and short the VIX when the spot price is elevated (e.g. above 20 or 25).
      I don’t think it’s a good idea to “short” high beta funds, though. It’s very cumbersome and costly. See this vintage post of mine from last year:
      https://earlyretirementnow.com/2016/10/19/shorting-an-inverse-etf-is-a-bad-idea-or-why-beta-slippage-isnt-alpha/
      I’d rather trade the VIX futures myself!
      Thanks for stopping by!
      Cheers,
      ERN

      Like

      • Theres a lot to unpack with volatility trading and its hard to do in one post. The point of something like XIV, which shouldnt be invested in since its an ETN and has additional counter party risk in addition to unfavorable tax treatment, as opposed to the similar SVXY or VMIN which are ETFs and since they hold futures get the very beneficial 1256 tax treatment.

        The point is one could replace a fairly large percentage of stocks with ‘safer’ assets with a small allocation to something like this. If you’re concerned about sharpes and dont want to learn the fairly simple way to mitigating any long draw downs, the much simpler play (outside futures as you note) is just a 3x SPY/QQQ fund. They will rarely if ever deliver a 150+% a year however.

        Get slightly more sophisticated and there are lots of ways to improve your safety/positioning or choices of what to go long or short to capture the volatility risk premium or the inherent terribly constructed product.

        Liked by 1 person

      • With respect to shorting etfs, you cant just go shorting random and especially broad market etfs. You have to find broken products with a lot of friction. No path dependency, limited/short term trending if any, futures costs, high ERs, and hopefully triple leveraged.

        Even then its hard because the borrow is painfully high, mainly because there are quite a few hedge funds that got on top of this a while ago.

        Liked by 1 person

          • I was meaning that article you referenced, but I agree that costs make it prohibitive for the most part. However, the more exotic the more likely they have tons of frictions. The real key to shorting etfs (in our imaginary costless universe) is to find a trendless, max leveraged, futures dependent product with high expense ratios. This usually turns out to be commodity 3x etfs. Theyre great shorts (both long/short pairs) sized appropriately in this universe, but alas its too expensive. One could use options I guess.

            In regards to VIX products this is UVXY, which loses about 86% per year. Borrow is oddly not too high for this product, though I hate shorting straight, shares can be bought in, etc…always at worst time. Options are your friend here. Gives you strike, risk, and most importantly control over duration which is your doubly leveraged friend.

            Liked by 1 person

  2. It is also worth mentioning that short vol is a VERY crowded trade right now. Weird things are happening in this corner of the market and the internet and I am absolutely fascinated by it. What happens when “it” really hits the fan and everybody’s stops get triggered? Do a bunch of obscure weirdo trades get their faces ripped off and that’s the end? Or does the contagion spill into the “regular” equity markets a la 1987? There’s certainly enough money sloshing around to move the needle.

    While a NYT article about a manager at Target shorting VXX and UVXY isn’t exactly a shoe-shine boy giving Kennedy stock tips…it’s pretty freaking close right? (https://www.nytimes.com/2017/08/28/business/dealbook/vix-trading.html)

    Full disclosure: long LEAPS puts on UVXY (albeit a small, experimental position).

    Anyway…nice post and explanation of XIV and it’s relationship to VIX. Anyone interested in a very deep dive on many of these exchange traded products should visit https://sixfigureinvesting.com

    Liked by 1 person

    • Wow, you are brave! I guess over the long-term the UVXY should melt down at a pretty rapid pace. Not a bad idea buying puts. But I would only dedicate money you can part with. 🙂
      Yeah, I remember that NYT article! It is a crowded trade! I’d be afraid if there’s a large enough shock it might cause margin calls for a lot of the short VIX folks. That would increase the buying pressure and drive the VIX futures price up even more. Classic short-squeeze!

      Nice link! I saw the sixfigureinvesting page before and liked the simulated backtest going back to 2004. -90% in 2007/8. Ouch! One aspect he must have misunderstood is this:

      I’m sure one aspect of XIV is a headache for Credit Suisse. Its daily reset construction requires its investments to be rebalanced at the end of each day, and the required investments are proportional to the percentage move of the day and the assets held in the fund. XIV currently holds $900 million in assets, and if XIV moves down 10% in a day (the record negative daily move is -24%, positive move +18 %) then Credit Suisse has to commit an additional $90 million (10% of $900 million) of capital that evening.

      That’s not right. CS will simply reduce the short position by x% in response to an x% drop in the value of the fund. As I mentioned above, this could create a self-fulfilling VIX surge. Creates buying pressure toward the end of the day when the VIX has already surged!

      Liked by 1 person

      • Yeah the decay rate is eye watering. It just went through it’s 8th reverse split in July and is already back down in the teens again (nearly 50% since the split). I don’t think the market maker’s robots are very good at pricing the LEAPS put premiums because the values of the greeks would have to be so extreme they can’t comprehend the actual pricing model.

        Regardless it’s just fun money for me. Never more than 3% of aggregated portfolio. Also I don’t usually hold the position for very long. After a about a month or two it seems to cap out around the 80-100% annualized return level which is good enough for me.

        I like the long put approach because it 1) caps the downside, 2) eliminates the need for margin (so I can do it in retirement accounts).

        I too appreciate sixfigureinvesting’s work on the backtesting through the financial crisis. I wish their were data for the dot com bust, but oh well.

        I’m not sure I follow what’s wrong with his assessment of the daily XIV re-balancing mechanism. As you said, “CS will simply reduce the short position by x% in response to an x% drop in the value of the fund”. Doesn’t “Reduce the short position by x%” mean buying x% worth of long position? The capital has to come from somewhere…right? I’ve read it a couple times now and I can’t get past the idea that you’re both saying the same thing slightly differently.

        Regardless, the moral of the story should remain: be careful with leverage and short volatility positions! GLTA!

        Liked by 1 person

        • I’m not sure I follow what’s wrong with his assessment of the daily XIV re-balancing mechanism. As you said, “CS will simply reduce the short position by x% in response to an x% drop in the value of the fund”. Doesn’t “Reduce the short position by x%” mean buying x% worth of long position? The capital has to come from somewhere…right?

          It’s just a minor detail. The capital wouldn’t come from anywhere. If the fund loses money in response to a VIX spike, it’s water under the bridge. The ETN has to reduce the notional exposure and buy back a fraction of the short VIX futures. Credit Suisse will most definitely not pump any of their own money into the fund to make up the loss.

          Like

    • Not as crowded as you think. People have been talking trash about it forever, all the while deeply misunderstanding it, and continuing to be wrong in the process. I’ve seen very smart people try to discuss this topic and utterly fail to accurately understand and convey worthwhile information.

      Obviously with any trade of this nature position sizing and understanding your exposure is the most important aspect of management.

      Liked by 1 person

      • When lawyers, dentists, “Target managers” etc. start raving about short-VIX, I think that’s the definition of a crowded trade.

        I’ve seen very smart people try to discuss this topic and utterly fail to accurately understand and convey worthwhile information.

        Do you include me in the group of folks misunderstanding worthwhile information?

        Like

        • No, you at least understand where the returns are generated and you can actually directly invest in the vix itself. Which is seriously magnitudes of difference from what gets floated out there. You’re biggest hangup is in the risk adjusted department, which causes you to just dismiss it. Thats not wrong as you can do better with 3x spy risk adjusted, ZIV (med term futures), and several other methods some of which you touched on. There are ways to do so with short vol but the trade requires quite a bit of attention and thats probably not what youre (and many others) looking for either.

          The definition of a crowded trade is one in which a side is overloaded to the extent a small move can cause a run in the opposite direction due to covering positions usually initiated within the crowded product. Though anything could happen, especially since this market just recently became bigger and more participatory, but since its not directly linked theres no reason for it to occur. Given its several degrees of derivation off of things, and your proximity to the actual VIX depends on your chosen exposure method (futures, options on the futures, etfs, spx options, etc…). Obviously, the most prominent feature of crowded trades is the positioning itself causes the issue. However, since the VIX complex is mostly reactive to the spx options which are reactive the the s/p, something has to happen elsewhere first, which does not jive with a trade being crowded. People have been saying similar for years (though not as loud as this one) and it still doesnt matter if vol doesnt appear.

          I could send you a white paper where someone looked at this and dismissed several of the ‘crowded’ arguments, though some of them were not that compelling. I have others that show % of futures that are etp controlled etc…and they still are not the major factor in futures volume. Most of the time positioning is net long, though its obviously terribly difficult to pin down the exact vega exposure since there are no rules on how or if someone/entity hedges.

          Liked by 1 person

  3. Good article, and great nugget here:

    “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.”

    I’m pretty dedicated to low cost index investing, and freely admit that derivatives and options fall outside my comfort zone – for now. But I like to learn about things outside my comfort zone, and certainly won’t criticize people that invest in products outside my comfort zone and who know what they are doing (Don’t criticize what you can’t understand – Bob Dylan). Markets and financial products have evolved over time, and I think investors who do well over the long haul learn about and adapt to those changes. Twenty years ago, index funds were a lot less common, and ETF’s virtually unheard of, and outside the comfort zones of many investors, who clung to individual stocks and actively managed funds. Yet now, low cost ETF’s and Index funds are pretty well proven to beat actively managed funds and stock picking.

    Perhaps trash talking indexers are an embodiment of the saying, “Radical ideas which threaten institutions become institutions which reject radical ideas because they threaten the institution.”

    Now you’ve got me thinking though. Derivatives as part of a well balanced portfolio is certainly something I plan to learn more about.

    Please keep the good posts coming. I’ve gotten to where I enjoy reading your posts over lunch each Wednesday.

    Liked by 1 person

  4. Super analysis thanks! Given there is no real investment thesis for a consistently declining VIX and there is no explicit risk premium (other than beta with equities and the weird contango effect) then I am out. And I would put it in the speculation, rather than Investment, bucket.

    Liked by 1 person

    • What do you mean no explicit risk premium? That is precisely what is available. It cant just be perfectly captured and is at risk at times of course, but thats exactly what you get. Doesnt matter if VIX declines at all. Only thing that matters is if someone pays for an implied volatility that doesnt manifest itself as realized volatility.

      I’ll quote Eli Mintz here, “volatility mean reverts but contango losses are forever”.

      Not sure how something with around a 70-90% win rate (depending on market environment) played straight up is given so much derision as pure speculation.

      Liked by 2 people

        • Thats a position sizing issue. The only way to be completely annihilated is to have 100% or more of your assets in these products, which would be crazy. There are plenty of simple to complex ways to increase your safety and or returns.

          I mean even a mindless buy/hold (which this product is not made for btw) would have returned over 1000% since inception. Thats not bad at all. Its up almost 500% since the bottom in february 2016. You could accuse me of cherry picking but with vol you can see regime changes and get in shortly after such events and capture almost all of that upside.

          The biggest downside to vol is its complicated, which if you’ve taken the (considerable) effort to learn about it is also its best feature.

          Liked by 1 person

  5. Want to see something really weird? Check the price of a UVXY January 2019 ATM short straddle. If you sold both the call and the put ATM ($16 strike), your revenue would be 23% more than the price of the underlying asset, meaning you could only lose if volatility went so high UVXY more than doubled.

    You take this chance on an asset whose design causes it to lose 80+% of its value each year due to being on the wrong side of contango. So if the next “volatility event” occurs 6 months from now, UVXY might have to quadruple for your straddle to go into the red.

    Also, note that companies like Credit Suisse and Powershares tend to operate both long and short VIX funds. The money from one comes from the other, as VIX seesaws. The left hand can sell contracts to the right hand.

    Liked by 1 person

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s