Just about anyone who’s looked at a multi-year chart for a long volatility fund like Barclays’ VXX has thought about taking the other side of the trade. ProShares’ SVXY is an Exchange Traded Fund (ETF) that allows you bet against funds like VXX while avoiding some of the issues associated with a direct short. Read More
Not Just Long or Short and No Signals
The indexes that power VelocityShares new BSWN, LSVX, and XIVH funds have been live since 2011, but they haven’t been directly accessible via exchange traded products until July 2016. The goals of these new funds are pretty straightforward, on the long side BSWN & LSVX track upside volatility with some fidelity while minimizing decay costs, while XIVH captures the premium typically available by being short volatility, but with a hedging component to reduce drawdowns during corrections and bear markets.
The technology backbone of these VelocityShares funds is quite simple—and counter-intuitive. Each of these Exchange Traded Notes (ETNs) tracks a mix of both long and short VIX futures. You’d think that the short and long positions would just cancel each other out—but they don’t.
The long positions are managed as a 2X leveraged fund (similar to TVIX), and the short positions as a –1X inverse fund (similar to XIV). Both long and short positions use daily end-of-day rebalancing to keep their daily percentage moves consistent with the moves of their underlying index (short term VIX Futures—SPVXSP) and their leverage factors. By selecting the weights of the long and short positions in these funds VelocityShares positioned them at three different points on the volatility spectrum—ranging from volatility spike catcher all the way to hedged inverse volatility.
The baseline allocations / strategies for these three funds are shown below:
|Ticker||2X long %||-1X short %||Strategy|
|BSWN||45%||55%||Tail Risk (strong long bias)|
|LSVX||33.33%||66.67%||Long / Short (long bias)|
|XIVH||10%||90%||Hedged short volatility (strong short bias)|
This simulation shows that the BSWN and LSVX portfolios managed to retain an impressive amount of value ($368 & $1724 respectively) over an eleven year period while the VXX and UVXY/TVIX portfolios withered away to nothing ($2.86, $0.00008) respectively).
The next chart shows the simulated behavior of XIVH compared to the popular XIV and SVXY -1X inverse volatility funds.
Wow, quite a ride—including a peak value of more than $12K for the XIVH portfolio followed by a drawdown to half of that in less than 2 years.
Over this time span, the 2008/2009 bear market was the key differentiator between these two funds. The 2X long allocation of XIVH’s portfolio beautifully protected it during the financial crisis.
The chart below compares the two funds starting immediately after the 2008/2009 bear market.
When starting in April 2009 XIV/SVXY has better absolute performance, but XIVH’s volatility and drawdown percentages are better. XIVH’s drawdown percentage during the 2011 correction was half of XIV/SVXY’s.
The Trend is Their Friend
Leveraged funds actually perform better than their leverage factors in trending markets. Consider the example of a hypothetical 2X leveraged fund where the underlying fund goes up 10% a day for three days:
|Day||Underlying %||Underlying||Underlying Cumulative % gain||2X leveraged
With daily reset
Cumulative % gain
Instead of the 66.2% gain you might have expected from the 2X leveraged fund, it went up 72.8%—a 6% bonus. See this post for a real world example of how the 2X long TVIX overachieved in this fashion.
Leveraged funds can also lose less than you’d expect in markets that are moving against them—if the underlying is strongly trending against them the percentage losses in the leveraged funds will be less than the leverage factor would indicate.
Winner Take All
The other key attribute of these funds is a “winner take all” characteristic. If there is a volatility spike the 2X long portion of the portfolio grows rapidly and the inverse portion shrinks rapidly. Fund allocations (e.g., initially 45% long, 55% short) dynamically shift towards the long side of things during a volatility spike –exactly what you’d like to see happen. Conversely, if volatility is slumping the funds dynamically shift their allocations towards the short side.
Some Reset Required
There are some downsides to using this long / short technology. With an unconstrained “winner take all” strategy the losing side of the portfolio shrinks to the point where there’s nothing to build on when the trend reverses—and the trend will always reverse. To address this issue the funds do periodic resets back to their initial weighting factors. However, this resetting introduces another problem—path dependency. Not only does it matter how much VIX futures move in price, it also matters when the VIX futures move relative to the reset schedule of the funds. For example, if a volatility spike occurs right before a reset it can have a significantly different impact on the fund’s value compared to a spike right after a reset.
The funds take a two-tiered approach to mitigate path dependency. Each of the funds is rebalanced back to its target weighting quarterly and there’s a weekly rebalance of a rotating subset of assets within the funds.
Volatility of Volatility is a Drag
Another downside of these funds is that they don’t do well if the values of the underlying VIX Futures are choppy. If VIX futures are up strongly one day, and down sharply the next these funds will suffer—both their trend compounding and their “winner-take-all” strategies take multiple days of trending action to work well. When volatility of volatility is high it drags down the performance of all leveraged funds—both long and short.
Not Great at Black Swans
Volatility spikes that ramp up quickly (e.g., flash crashes, overnight geopolitical / economic surprises) are not captured particularly well by the longish funds (BSWN, LSVX). If these funds are operating close to their target weights then the short side will significantly drag down the performance of the 2X long side during quick volatility jumps.
The short volatility oriented fund, XIVH would be at some risk of termination if a historically unprecedented volatility spike (e.g., VIX spike of >70%) occurred. These funds terminate if the intraday indicative value drops 80% or more from the previous day’s close. If this situation occurs the holder would likely receive somewhere between 0% and 20% of their previous day’s holdings in cash (no lower than zero). XIVH would be significantly less likely to terminate than standard inverse volatility funds (e.g., XIV/SVXY) because it maintains a 2X long position also.
No Signals Need Apply
Most volatility funds that aren’t just pure long or short plays rely on algorithms to monitor market parameters (e.g., VIX moving averages) and then generate signals that cause allocations to be shifted. I’ve listed some of these funds and the parameters they monitor.
|VQT, PHDG||S&P 500 volatility, VIX 5 & 20-day moving averages, Fund losses|
|VQTS||S&P 500 volatility, VIX Futures Term Structure|
|XVZ||VIX term structure (VIX/VXV)|
|VIXH||VIX Future absolute prices|
BSWN, LSVX, and XIVH and two other VelocityShares funds (TRSK and SPXH) do not make allocations based on signals, nor do they rely on any characteristics outside the underlying short term futures themselves. They don’t shift allocations based on the term structure between short and medium-term VIX Futures, VIX term structure, VIX volatility or S&P 500 historic volatility.
I think this self-sufficiency is a significant advantage. The volatility landscape is relatively young, with VIX futures only trading since 2004. The interplay between VIX futures of various expirations, the VIX, and equity markets has evolved over time and I don’t see any indication those relationships have stopped shifting. By avoiding linkages to these factors BSWN, LSVX, and XIVH should exhibit more consistent behavior over time compared to the other strategy funds. But to be clear, they do have their dependencies—specifically the trendiness and volatility of the underlying short term VIX futures index.
Complicated Fee Structure
The issuer of these ETNs, the Swiss bank UBS, has levied a complex transaction fee in addition to the annual fee (1.3%). The “Futures Spread Fee” captures some of the costs associated with the daily rebalancing of the funds’ long and short positions. I’m guessing this fee will increase the annual costs associated with owning these funds by around 0.3%.
Low Volume and Low Asset Base
Initially these funds will have low volumes and relatively low asset levels. This naturally leads to concerns about liquidity. In reality, the liquidity of all Exchange Traded Products is critically dependent on the nature of the underlying securities they track. If the underlying index of an ETP is based on small-cap stocks in a 3rd world country then great care is required for all but the smallest trades, however in the case of these VelocityShares ETPs, their underlying is short term VIX futures—which are high volume, very liquid securities. As a result, traders will find that with a little care they can make large purchases or sales without significantly shifting the prices of these funds. For more information and suggestions on trading low volume funds see Evaluating ETP liquidity and Trading Low Volume ETPs.
Hedging Hurdle—How Much Decay?
Funds that are effectively long volatility are attractive candidates for hedging equity portfolios because volatility reliably spikes up when stocks plummet. Unfortunately when the market isn’t panicking long volatility positions often decay quickly. One approach to get around this decay is to apply these hedges only during high-risk times. However, corrections / bear markets are notoriously difficult to predict—if crystal balls were that good there’d be no need for hedging. Since BSWN and LSVX’s decay rates are relatively low holding them all the time becomes a viable option.
The chart below shows historical monthly decay rates.
This simulation shows that the decay of VelocityShares’ BSWN and LSVX would have been dramatically lower than TVIX/UVXY and VXX during relatively quiet markets—BSWN decaying mostly in the 1% to 2% per month range and LSVX running in the -1% to +1% range.
How Much Oomph do BSWN and LSVX Have?
While low ongoing losses are very important for any potential hedge strategy it’s also important to know how much these funds will likely jump when a volatility event occurs. This jump data helps establish the required “hedge ratio”—the percentage of a portfolio’s assets that should be held in a long volatility fund to compensate for the losses in the rest of the portfolio during a market correction / crash.
The chart below shows the peak percentage increases in VIX, UVXY, VXX, BSWN, and LSVX during some historical volatility spikes—some of which lasted months, others a day or two.
Not surprisingly, in the jump category UVXY is the top performer for investible securities, with VXX coming in second most of the time. BSWN and LSVX perform very well during longer, more severe events—not a bad characteristic to have.
Traversing the Volatility Landscape
Volatility investing has been a minefield for investors. If you’re long volatility you expose yourself to devastating decay losses if your timing isn’t perfect. Alternately if you’re short volatility you risk being blown up by vicious volatility spikes.
VelocityShares’ long/short strategy funds allow us to mitigate risk on both sides of the spectrum using a technology that doesn’t rely on backtested volatility signals or VIX future term structure assumptions. The indexes the BSWN, LSVX, and XIVH funds are based on have been published since 2011 and have performed appropriately through a wide range of market conditions. I expect them to continue doing their jobs well.
- VelocityShares websites: BSWN, LSVX, XIVH
- Prospectus for BSWN, LSVX, XIVH
- Hedging Equity Volatility with VIX-Based Instruments
- Volatility Strategies Explained: Long & Short VIX Strategies
- S&P 500 VIX Futures Long/Short Strategy Methodology
- Chart of performance of long funds using log scale
- Chart of performance of short funds using log scale
VelocityShares’ XIV and its sister fund ZIV are designed to go up when the volatility of the S&P 500 goes down. XIV has a shorter time horizon (1 to 2 months) whereas ZIV has a 5-month timeframe.
To have a good understanding of how XIV works (full name: VelocityShares Daily Inverse VIX Short-Term ETN) you need to know how it trades, how its value is established, what it tracks, and how VelocityShares (and the issuer— Credit Suisse) make money running it.
How does XIV trade?
- XIV trades like a stock. It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods. With an average daily volume of 29 million shares its liquidity is excellent and the bid/ask spreads are a penny.
- Unfortunately, XIV does not have options available for it. However, its Exchange Traded Fund (ETF) equivalent, ProShare’s SVXY does, with five weeks’ worth of Weeklys with strikes in 50 cent increments.
- Like a stock, XIV’s shares can be split or reverse split—but unlike VXX (with 4 splits since inception) XIV has only split once, a 10:1 split that took its price from $160 down to $16. Unlike Barclays VXX, XIV is not on a hell-ride to zero.
- XIV can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security. Shorting of any security is not allowed in an IRA.
How is XIV’s value established?
- Unlike stocks, owning XIV does not give you a share of a corporation. There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends. Forget about doing fundamental style analysis on XIV. While you’re at it forget about technical style analysis too, the price of XIV is not driven by its supply and demand—it is a small tail on the medium sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion).
- The value of XIV is set by the market, but it’s tied to the inverse of an index (S&P VIX Short-Term Futurestm) that manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts. Every day the index specifies a new mix of VIX futures in that portfolio. This post has more information on how the index itself works.
- The index is maintained by the S&P Dow Jones Indices and the theoretical value of XIV if it were perfectly tracking the inverse of the index is published every 15 seconds as the “intraday indicative” (IV) value. Yahoo Finance publishes this quote using the ^XIV-IV ticker.
- Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of XIV diverges too much from its IV value. If XIV is trading enough below the index they start buying large blocks of XIV—which tends to drive the price up, and if it’s trading above they will short XIV. The APs have an agreement with Credit Suisse that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep XIV’s tracking in good shape.
What does XIV track?
- XIV makes lemonade out of lemons. The lemon in this case is an index S&P VIX Short-Term Futurestm that attempts to track the CBOE’s VIX® index—the market’s de facto volatility indicator. Unfortunately, it’s not possible to directly invest in the VIX, so the next best solution is to invest in VIX futures. This “next best” solution turns out to be truly horrible—with average losses of 5% per month. For more on the cause of these losses see “The Cost of Contango”.
- This situation sounds like a short sellers dream, but VIX futures occasionally go on a tear, turning the short sellers’ world into something Dante would appreciate.
- Most of the time (75% to 80%) XIV is a real money maker, and the rest of the time it is giving up much of its value in a few weeks—drawdowns of 80% are not unheard of. The chart below shows XIV from 2004 using actual values from November 2010 forward and simulated values before that.
- Understand that XIV does not implement a true short of its tracking index. Instead, it attempts to track the -1X inverse of the index on a daily basis and then rebalances investments at the end of each day. For a detailed example of what this rebalancing looks like see “How do Leveraged and Inverse ETFs Work?”
- There are some very good reasons for this rebalancing, for example, a true short can only produce at most a 100% gain and the leverage of a true short is rarely -1X (for more on this see “Ten Questions About Short Selling”. XIV, on the other hand, is up almost 200% since its inception and it faithfully delivers a daily move very close to -1X of its index.
- Detractors of the daily reset approach correctly note that XIV and funds like it can suffer from volatility drag. If the index moves around a lot and then ends up in the same place XIV will lose value, whereas a true short would not, but as I mentioned earlier, true shorts have other problems. However, daily reset funds don’t always underperform. If the underlying index is trending down, they can deliver better than -1X cumulative performance. For more see “A Hat Trick for Inverse / Leveraged Volatility Funds”
How do VelocityShares and Credit Suisse make money on XIV?
- Credit Suisse collects a daily investor fee on XIV’s assets—on an annualized basis it’s 1.35%. With current assets at $900 million this fee brings in around $12 million per year. That should be enough to cover Credit Suisse’ XIV costs and be profitable. But even if it was all profit it would be a tiny 0.3% of Credit Suisse’s overall net income—$2.6 billion in 2013. My understanding is that a portion of this fee is passed onto to VelocityShares for their technical and marketing activities.
- 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. If XIV goes down 10% the next day, then another $81 million infusion is required.
- Unlike an Exchange Trade Fund (ETF), XIV’s Exchange Traded Note structure does not require Credit Suisse to report what they are doing with the cash it receives for creating shares. The note is carried as senior debt on Credit Suisse’s balance sheet but they don’t pay out any interest on this debt. Instead, they promise to redeem shares that the APs return to them based on the value of XIV’s index.
- Credit Suisse could hedge their liabilities by shorting VIX futures in the appropriate amounts, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge. ETFs like ProShare’s SVXY can use swaps also, but they usually just use the futures. The picture below is a snapshot of their holdings on August 12th, 2016. The parenthesis denote a short position in the futures.
XIV won’t be on any worst ETF lists like Barclays’ VXX, but its propensity to dramatic drawdowns will keep it out of most people’s portfolios. Not many of us can sit tight with big losses on the hope that this time will not be different.
It’s interesting that an investment structurally a winner albeit with occasional setbacks is normally not as popular as a fund like VXX that is structurally a loser but holds out the promise of an occasional big win.
Slow and unsteady is trumped by a lotto ticket.
For more information
I have generated the end of day trading day values for the most popular long and short volatility Exchange Traded Products (ETPs) for March 26th, 2004 through February 28th, 2017
These ETP histories are required if you want to backtest various volatility strategies through the quiet times from 2004 to 2007, or the 2008/2009 crash. The chart below shows the simulated values with a logarithmic vertical axis so that you can see a reasonable amount of information for each fund.
The algorithms for generating these ETPs values are documented in the prospectuses for the various volatility ETNs and ETFs. Barclays’ VXX/VXZ fund prospectus is a good example. See Volatility tickers for the current universe of USA based volatility ETPs and their associated reference indexes. The futures settlement data required for these calculations is available on this CBOE website—in the form of 100+ separate spreadsheets. To make the calculation of the indexes underlying the ETPs tractable I created a master spreadsheet that integrates the futures settlement data into a single sheet. See this post for more information about that spreadsheet.
With the exception of TVIX—which has had severe tracking problems since early 2012 my simulated values very closely track the published indicative values (IV) of the funds. Barclays provides a full set of IV values for VXX and VXZ—my simulation tracks them within +-0.04% and +-0.025% respectively. Sampled IV values for the other funds give error terms of +-0.2% for Proshares UVXY, and for VelocityShares XIV and ZIV +-0.2% and +- 0.01% respectively. My TVIX simulation tracks sampled IV values within +2%/-4%.
If you need simulated intraday open, high, low values also check out this post.
These ETP prices reflect the contribution of 91 day treasury bills on their overall performance. Thirteen-week Treasuries yields averaged 0.05% in 2013, but in February 2007 they yielded over 5%— things have changed a bit… The simulated ETP values do include applicable fees which vary from fund to fund. The fee calculation is surprisingly difficult. For more on that see Backtest on VXX Including Annual Fees
I am making these 6 simulation spreadsheets (values only, no formulas) available for purchase, individually, or as a complete package. The VXX package is also available here. If you cannot see purchase information immediately below then please click this link to the stand-alone post and look at the bottom of the page.
For more information on the spreadsheets see readme.
If you purchase the spreadsheet you will be directed to paypal within a few minutes where you can pay via your paypal account or a credit card. When you successfully complete the paypal portion you will be shown a “Return to Six Figure Investing” link. Click on this link to reach the page where can download the spreadsheet. Please email me at [email protected] if you have problems, questions, or requests. It’s easy to miss the “Return to Six Figure Investing” link. If you don’t get it / can’t find it please email me.
- Top 10 Questions about Dividends
- Ex-Dividend and Pay Dates for Lots of ETFs
- Dividend Capture Strategies
- Top 15 Questions about Trading in an IRA
- Trading in an IRA and Avoiding "Free Riding"
- Review of StreetSmart Edge
- Free Option Charts
- How to Go Long on the VIX
- Going Short on the VIX
- Going Short on VXX
- Inverse Volatility—The Winner is XIV
- How Much Should We Expect the VIX to Move?