I used to share stock tips with my brother-in-laws. Before the tech crash I could offer up a few stocks I liked, and they would often make some money. The crash painfully ended the easy money and I moved onto index funds. They didn’t think indexes were near as much fun.
This Easter one of my brother-in-laws asked what I was investing in. My response was “inverse volatility.” I might as well have said pixie dust. I stood there wondering where (or if) to start. First you have stocks, then you have the S&P 500, then you options on the S&P 500, then you have implied volatility calculations, then you have futures on volatility, then you have ETNs with rolling mixtures of futures on volatilty (VXX), and then you have the inverse (or the short) of that. We looked each other in the eye and wordlessly agreed that we wouldn’t start.
I like inverse VXX/VXZ investing. It’s seldom boring and over the long run the advantage is on your side. Volatility has a return to mean behavior, and volatility futures are almost always in contango—which erodes the value of VXX. If you buy inverse volatility when the VIX is relatively high, your chances of making a good profit eventually are very good.
Currently there are ten choices in inverse volatility ETN/ETFs. Barclays offers the XXV and IVOP ETNs which emulate short positions in VXX, VelocityShares offers XIV (daily percentage inverse of VXX), and ZIV (daily percentage inverse of medium term VXZ), and UBS offers a family of 6 funds, very similar to XIV and ZIV except they cover 1 month to 6 month terms in one month intervals. I have not evaluated UBS’s funds, but I expect they will be equivalent to VelocityShare’s offerings except for currently being less liquid, with wider spreads.
In rating the Barclay and VelocityShare funds I think there are three primary factors:
- Liquidity (small bid-asked spreads, getting good fills on orders)
- Leverage
- Risk
ZIV’s daily volume is typically around 10K shares so its not great from a liquidity standpoint—I’m down to three choices.
On leverage XIV is simple, its goal is negative one-to-one for VXX’s daily percentage moves. The leverage of XXV and IVOP is not so simple.
It turns out that the daily percentage leverage of a short position is a variable which changes as the equity changes in price. For example, if you short XYZ stock at $100, the first $1 move either way delivers 1X leverage—you gain or lose $1,which is +-1/100 = +- 1% . But the further you get from that initiating price, the more the daily leverage changes.
For example, imagine after you sell XYZ short at $100 it drops like a rock to $2/share. If it drops the next day from $2 to $1.5, it’s a 25% daily move—but the value of your short position only changes from $98 to $98.5 per share. That’s a 0.5% move and the leverage, 0.5%/25% is only 0.02X. Conversely, if XYZ moves to $150 after you short it at $100, a $1 daily move down (0.67%) changes your position value from $50/share to $51/share—a 2% move which is 2%/.67% = 3X leverage. The graph below shows this relationship.
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XXV, IVOP, XIV leverage vs VXX, click to enlarge
The drop off to zero leverage on IVOP and XXV is Barclays’ ”Automatic Termination Event” that stops out their inverse funds if they drop below $10 per share. This prevents these funds from going negative. This termination is a real risk for the Barclay products, IVO was terminated in September 2011 when VXX went above $49.5 per share. IVOP will terminate if VXX goes above approximately 63.
Barclays ETNs only have 1X leverage when VXX is at their inception price, which is 41.55 for IVOP and 108.03 (split adjusted) for XXV. I think this is a terrible aspect of Barclays’ funds. When things are going in your favor (volatility dropping) your leverage is dropping, and it climbs rapidly when volatility is spiking—the opposite of what you would like. This loss of leverage as VXX declines forced Barclays to introduce IVO, because XXV leverage had dropped so low. In the future as contango grinds away at the VXX value Barclays will need to introduce a follow-on to IVOP to get their leverage back up near the 1X range. XIV is a clear winner on leverage.
Regarding risk, these are volatile products. They will get hammered when volatility spikes up. In the August/September 2011 correction XIV dropped from 19 to 6.5, a 66% drop in a few weeks. If the market goes into a major bear mode it might take a long time to recover your losses. Recent history has shown that daily percentage funds like XIV weather volatility spikes better than true shorts like IVOP, or the departed IVO. XIV is a clear winner on termination risk—it is much less likely to automatically stop out investors. See this post for more information on termination.
Although all inverse volatility funds benefit from the normal contango term structure of volatility futures, they aren’t reasonable buy and hold choices for investors. Investors should hedge, or go to the sidelines if the market looks “toppy”. All your gains can evaporate in a big hurry if the market corrects or crashes.
Will Barclays respond to XIV’s growing success by introducing a 1X leverage fund? I doubt it. They have a great situation with XXV and IVOP—every dollar invested in these funds is a perfect hedge against their other short term volatility product: VXX. They can skip the hedging expenses on both sides because they hedge each other, and Barclay can collect their %0.89 annual fee, risk free.
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