Betting on VIX Volatility: It Worked Until It Didn’t Work
(March 16, 2018) – On February 6, after a day that saw VIX volatility (the Chicago Board Options Exchange Volatility index forever known as Wall Street’s “fear index”) spike from 17 to 37 owing to a 4% decline of the S&P 500, Credit Suisse announced an “event acceleration” of VelocityShares’ Daily Inverse VIX Short-Term ETN—or XIV, for short– thus driving a stake through the heart of this hedge fund darling. A memorial service for XIV, which plummeted in value from 100 to 5 and triggered a “poison pill” provision whereby the security can be called if the price goes down in a single day by more than 80%, was held on February 21, its redemption date.[1] Professional traders everywhere offered thoughts and prayers before removing the deceased financial instrument from their Bloomberg terminals.
The demise of XIV sent shockwaves through the financial blogosphere, with numerous pecuniary pundits suggesting that in the future ETF’s should come with warning labels. But investors need to understand an important distinction among today’s alphabet soup of investment products; ETN does not equal ETF.
ETF vs. ETN: Whats the Difference?
An ETF owns the asset it tracks. That asset may be stocks, bonds, commodities or futures contracts. They’re like mutual funds, except an ETF trades like a common stock on an exchange and experiences price changes throughout the day as they are bought and sold.
ETNs, however, hold no assets. They are a type of debt security that trade on exchanges and promise a return linked to a market index or other benchmark.[2] They are unsecured debt obligations of the issuer—Credit Suisse, in the case of XIV. The issuer promises to pay the holder of the ETN an amount determined by the performance of the underlying index or benchmark on the ETN’s maturity date. For those who desire more bang for their buck, some ETNs offer leveraged exposure to the index or benchmark they track, which means they promise to pay a multiple of the performance of the underlying index or benchmark. Then there’s inverse ETNs, such as XIV, which offer to pay the opposite of the performance of the index or benchmark they track. And for those who fancy walking a tightwire over the Grand Canyon without a safety net, there’s the leveraged inverse ETN, a potential eye-popping investment instrument equipped with the explosive charm of a roulette table.
XIV was designed to be a short-term trading tool replicating the inverse of the daily performance of the S&P 500 VIX Short-Term Futures Index (SPVIXSTR), whose value is based on a hypothetical portfolio of the two nearest to expiration CBOE Volatility Index (VIX) futures contracts. SPVIXSTR is maintained by the S&P Dow Jones Indices who, if it were perfectly tracking the inverse of the index, published the theoretical value of XIV every fifteen seconds (the IV, or “intraday indicative value). The value of XIV was set by the market, but it was linked to the daily inverse return of the index and did not represent a long-term investment in the inverse of the VIX[3]. Investors who took the time to read the XIV prospectus should have taken notice of the frequent use of the term “daily.” XIV was designed to be rented, not owned.
At its core, the value of XIV was supposed to go up when VIX went down. As the stock market enjoyed an exceptional nine-year bull market, the VIX has remained suppressed, and XIV, which began trading on November 29, 2010, thrived. During this period through January 2018, XIV had returned nearly 1200%, whereas the S&P 500 only doubled[4].
So, what happened?
One of the hottest trades among hedge funds and quant desks this year has been to short volatility, a.k.a.“short vol,” whereby one creates a position than benefits from an erosion of volatility in the stock market. According to FactSet, since the start 2018, The ProShares Short VIX Short-Term Futures (SVXY) and XIV—the two largest short-VIX products—took in $2.2 billion combined, nearly doubling their combined assets to more than $4 billion by February 2.[5] In fact, VIX-linked exchange traded products (ETNs and ETFs) net short exposure hit a record high on Thursday, February 1.[6] Moreover, because volatility in the stock market had become almost non-existent over the past twelve months, the VIX assumed a contango structure, i.e., its distant futures were more expensive than its prompt future futures. Therefore, as XIV rolled from the prompt future to the next month’s future, it benefited from this difference every month. In calm periods, the difference between the two contracts hovered around 5%, so it’s not too hard to see why owning XIV offered exceptional returns during the 2017 bull run. Plus, the upward slope of the VIX futures curve provided a tailwind for “short vol” securities such as XIV. It was the carry trade in reverse, and it was just too easy to make money.
But a funny thing happened on the smooth march to DJIA 30,000. The stock market hit an air pocket and began to experience strong turbulance, causing volatility to rip to the upside, and the short vol trade began to rapidly unwind. In early trading on February 6, the VIX spiked above 50, a level it hadn’t seen since 2009. Because of the inverse nature of XIV, it was forced to buy high and sell low, an investment scenario only Dante would appreciate. According to Reuters, XIV notes were worth a combined $1.6 billion on Friday, February 2, but ended Tuesday, February 6 at a more-than-92% discount to their closing value the prior day.[7]
A CNBC talking head once described XIV as “an ETN tracking futures tracking an index tracking options on an index.”[8] Who wouldn’t want to own something like that, especially when it was working so well? But in the financial blink of an eye it didn’t work so well. Tidjane Thiam, Credit Suisse CEO, summed it up best: “Yes, it (XIV) has had a lot of attention, because this kind of short vol/long S&P trade was run by a lot of people at their own risk, and it worked well for a long time until it didn’t—which is generally what happens in markets.”[9]
XIV is dead. Long live XIV.
- “Credit Suisse CEO defends enabling volatility bets with XIV,” MarketWatch.com, February 17, 2018
- “Exchange-Traded Notes-Avoid Unpleasant Surprises,” FINRA.org.
- “How Does XIV Work?” Sixfigureinvesting.com, February 6, 2018.
- “VelocityShares Daily Inverse VIX ST ETN (XIV)”, Yahoofinance.com
- “Era of Calm Ends as Volatility Returns to Markets,” Wall Street Journal, February 6, 2018
- “Volatility Spike Boosts U.S. Options Hedging Activity,” Reuters.com, February 7, 2018
- “Credit Suisse Defends Controversial Financial Product,” CNBC.com, February 7, 2018
- “Money is rushing into ‘the most dangerous trade in the world,’” CNBC.com, July 7, 20
- “Credit Suisse CEO defends enabling volatility bets with XIV,” MarketWatch.com, February 17, 2018