How Does XIV Work?

Friday, May 16th, 2014 | Vance Harwood
 

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?

  • For the most part 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 11 million shares its liquidity is excellent and the bid/ask spreads are a penny.
  • Unfortunately XIV does not have options available on it.  However its Exchange Traded Fund (ETF) equivalent, ProShare’s SVXY does, with five weeks’ worth of Weeklys with strikes in dollar increments.
  • Like a stock, XIV’s shares can be split or reverse split—but unlike VXX (with 3 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.  For more information on how the index itself works see this post or the XIV prospectus.
  • 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.
XIV-04-14

 

  • To be specific 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 $600 million this fee brings in around $8 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 amount of assets held in the fund.   XIV currently holds $600 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 $60 million (10% of $600 million) of capital that evening.  If XIV goes down 10% the next day, then another $60 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 often just deal with the futures.  The picture below is a snapshot of their holdings on May 13th,2014.  The parenthesis indicate a short position in the futures.
svxy-hold



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 loses 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 



Backtests for Popular Long & Short Volatility Exchange Traded Products

Friday, February 28th, 2014 | Vance Harwood
 

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 January 27th, 2014

  • TVIX    VelocityShares Daily 2x VIX Short-Term ETN
  • UVXY  ProShares Ultra VIX Short-Term Futures ETF
  • VXX     Barclays S&P 500 VIX Short-Term Futures ETN
  • VXZ     Barclays S&P 500 VIX Mid-Term Futures ETN
  • XIV     VelocityShares Daily Inverse VIX Short-Term ETN
  • ZIV     VelocityShares Daily Inverse VIX Medium-Term ETN
  • SVXY  ProShares VIX Short-Term Futures ETF
  • VIXY  ProShares  Short VIX Short-Term Futures ETF

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.

Pop-Vol-ETPs

 

The table below shows how much $1000 invested in each of these funds on March 26th, 2004 would have been worth on October 15th, 2013:
 
Symbol $ Value
TVIX $0.00012
UVXY $0.00014
VXX $2.10
VXZ $217
ZIV $1565
XIV $17865

 

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.

My simulated values very closely track the published indicative values (IV) of the funds except for VelocityShares’ TVIX—which has had severe tracking problems since early 2012.  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%.

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 eventually be directed to paypal 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 vh2solutions@gmail.com if you have problems, questions, or requests.



Under the hood of TVIX and XIV—Cause for Concern

Wednesday, October 3rd, 2012 | Vance Harwood
 

Since Credit Suisse’s recent pause on TVIX share creations I have been trying to figure out some of the hedging / rebalancing dynamics underlying the current crop of volatility ETNs and ETFs.  Traditional equity ETFs like SPY, the S&P 500 index tracking  fund don’t  require much behind-the-scenes action.   Shares are created or redeemed in conjuction with baskets of securities changing hands.  The only dynamic part is when the S&P index itself adds or deletes stocks or perhaps shuffling of shares for tax purposes.

Volatility ETNs/ETFs on the other hand use VIX futures, which themselves have only been in existence 8 years, as the underlying securities.   Rather than statically holding onto these futures all volatility funds must continually roll their futures holdings from nearer month maturities to further out months so that their effective time maturity stays constant.  In addition, except for Barclays’ offerings all inverse & leveraged volatility funds are designed to track the daily percentage move of their underlying index.  This attribute requires the funds to rebalance their holdings as often as daily to maintain their percentage tracking.     ETNs have some leeway on how they do this management of the underlying futures.  They for example can adjust the amount of hedging they have to do based on their overall portfolio (e.g., assets in XIV would partially hedge TVIX).

ETFs (e.g., ProShares UVXY 2X short term) require actual futures to change hands when shares are created or redeemed, but once held by the ETF provider they still have to do the dynamic rolling / rebalancing on the portfolio.  What you get back will be different than what you put in…

I’m concerned that the volatility ETN/ETFs are moving the market  itself with their trading: futures prices, term structure, and perhaps even the IV skew of SPX options.    It can’t help that the futures market rebalancing required to hedge vega, the volatilty of volatility, is in the same direction for both long funds like TVIX as it is for XIV and other inverse funds—the vega risk does not offset.    While scary, my analysis on the topic suggests that big VIX futures purchases probably have an overall neutral effect on the market.  The hedging activities of the market makers tend to offset the effects of VIX futures creation.

Volatility is a new asset class, and clearly it has gotten big enough to start showing growing pains.   I’m confident that the quest for profits will lead to solutions for these problems, but it will take some time to sort this all out.  I applaud Credit Suisse for having the internal controls and the willingness to take action when they saw the asset size exceed their limit.

 



XIV during the 2008 Crash

Wednesday, September 25th, 2013 | Vance Harwood
 

XIV has only existed since November 2010, so we are dependent on simulations for guesses on its performance before that.   The index that XIV is based on goes back into the 2005 time frame, so I have the data I need to backtest XIV for the 2008 crash.    My simulations show a close  match to actual XIV values (see this post) so I have a lot of confidence in my approach. Of course, if we had had XIV back in 2008 the whole course of history might have changed—but probably not.

I have used the pre-split values of XIV to make the chart easier to read.  To compare to the current 10:1 reverse split values, divide the XIV values by 10.

XIV during 2008/2009 crash, click to enlarge

.

.

.

.

.

.

.

.

As you would expect, XIV gets hammered—to the tune of 83% in the first phase of the crash.   XIV hits bottom the 20th of November 2008, which was 131 trading days into the 487 days of the crash—about 25% in.   Because this drop was spread out over time XIV would have never gotten close to its one day 80% drop termination event.  See this post for more information on XIV termination.  The S&P 500 didn’t bottom out until 4 months later in March 2009 which was about 200 trading days in.

For the four months from the XIV bottom until March of 2009 the simulated XIV is basically flat.  The twin forces of mean reversion of volatility, and backwardation of the volatilty futures contracts cancelling each other.  Only after we entered into the bull market did XIV start its sustained climb.



Is XIV behaving correctly?

Thursday, August 25th, 2011 | Vance Harwood
 

In spite of its name, XIV is not the inverse of the VIX index—it is the daily percentage inverse of a index called SPVXSP, which you can monitor on Bloomberg here.  This index very closely tracks the same index that VXX uses, SPVXSTR.

Last week XIV did not track VXX’s daily moves particularly well.   There has been a lot of speculation about what was causing this disruption—ranging from turmoil in the futures markets, XIV’s daily re-balancing, to the heavy backwardation in the soon-to-expire August volatility futures.

Below I have ploted VXX and XIV against the values they should have based on the index:

VXX & XIV vs SPVXSTR, click to enlarge

.

.

.

.

.

.

.

.

.

Things do not look seriously out of wack.  Most importantly, we aren’t seeing a divergence between the index and the VXX/XIV prices.  Daily errors are being compensated for over time. The next graph shows the daily VXX/XIV divergence from the index in percent.   The interesting thing here is that VXX is having trouble tracking too—it’s just in the positive direction.

VXX and XIV tracking error, click to enlarge.

.

.

.

.

.

.

.

.

.

Looking at these graphs I’m inclined to say that the tracking problems are not specific to XIV, but rather due to the volatility/disruption of the futures market associated with the S&P downgrade.

.