Vance Harwood I March 10, 2017
Update: VXX was the first Exchange Traded Notes (ETNs) available for volatility trading in the USA. It has been a successful product but had a built-in maturity date causing it to retire in January 2019. In response, Barclays Bank PLC, the issuer of the ETN, created VXXB which is nearly identical to its predecessor. It has the same management fee (0.89%) and tracks the same index (SPVXSTR). One difference noted in the prospectus is an “Issuer Call” feature. This provision allows the issuer to shut down the fund if they wish, without cause, and pay the shareholder the share’s value at that point in cash. This is similar to most other ETNs and ETFs and has become industry standard.
In this article, I will discuss what VXXB is (full name: iPath Series B S&P 500 VIX Short Term Futures ETN ), how it trades, how its value is established, what it tracks, and how Barclays makes money running it.
How does VXXB trade?
For the most part VXXB 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 75 million shares its liquidity is excellent and the bid/ask spreads are a penny.
It has a very active set of options available, with five weeks’ worth of weeklys and close to the money strikes every 0.5 points.
Like a stock, VXXB’s shares can be split or reverse split— 4:1 reverse-splits are the norm and can occur once VXXB closes below $25.
VXXB 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 VXXB’s value established?
Unlike stocks, owning VXXB 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 VXXB.
The value of VXXB is set by the market, but it’s closely tied to the current value of an index (S&P VIX Short-Term Futures) 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.
The index is maintained by the S&P Dow Jones Indices and the theoretical value of VXXB if it were perfectly tracking the index is published every 15 seconds as the “intraday indicative” (IV) value. Yahoo Finance publishes this quote using the ^VXXB-IV ticker.
Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of VXXB diverges too much from the IV value. If VXXB is trading enough below the index they start buying large blocks of VXXB—which tends to drive the price up, and if it’s trading above they will short VXXB. The APs have an agreement with Barclays that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep VXXB’s tracking in good shape.
What does VXXB track?
Ideally VXXB would track the CBOE’s VIX® index—the market’s de facto volatility indicator. However since there are no investments available that directly track the VIX Barclays chose to track the next best choice: VIX futures.
Unfortunately using VIX futures introduces a host of problems. The worst is horrific value decay over time. Most days both sets of VIX futures that VXXB tracks drift lower relative to the VIX—dragging down VXXB’s value at the average rate of 4% per month (30% per year). This drag is called roll or contango loss.
Another problem is that the combination of VIX futures that VXXB tracks does not follow the VIX index particularly well. On average VXXB moves only 55% as much as the VIX index.
Most people invest in VXXB as a contrarian investment, expecting it to go up when the equities market goes down. It does a respectable job with the VXXB averaging percentage moves -2.94 times the S&P 500, but 16% of the time VXXB has moved in the same direction as the S&P 500. The distribution is shown below:
VXX% moves / SPX% moves (SPX daily moves of less than +/-0.1% are excluded)
With lethargic tracking to the VIX, erratic tracking with the S&P 500 and heavy price erosion over time, owning VXXB is usually a poor investment. Unless your timing is especially good you will lose money.
How does Barclays make money on VXXB?
Barclays collects a daily investor fee on VXXB’s assets—on an annualized basis it adds up to 0.89% per year. With current assets at $1.15 billion this fee totals around $10 million per year. That’s certainly enough to cover Barclays’ VXXB costs and be profitable. But even if it was all profit it would be a tiny 0.1% percent of Barclays’ overall net income— which was $10.5 billion in 2012.
From a public relations standpoint VXXB is a disaster. It’s frequently vilified by industry analysts and resides on multiple Worst ETF Ever lists. You’d think Barclays would terminate a headache like this or let it fade away, but they haven’t done that even though 3 reverse splits—which suggests that Barclays is making more than $10 million a year with the fund.
Unlike an Exchange Trade Fund (ETF), VXXB’s Exchange Traded Note structure does not require Barclays to specify what they are doing with the cash it receives for creating shares. The note is carried as senior debt on Barclays’ 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 VXXB’s index—an index that’s headed for zero.
If Barclays wanted to fully hedge their liabilities they could hold VIX futures in the amounts specified by the index, but they almost certainly don’t because there are cheaper ways (e.g., swaps) to accomplish that hedge. If fact it seems likely Barclays might assume some risk and not fully hedge their VXXB position. According to ETF.com’s ETF Fund Flows tool, VXXB’s net inflows have been $5.99 billion since inception in 2009—and it currently holds $1.15 billion. So $4.8 billion dollars has been lost by investors and an equivalent amount by Barclays if they were hedged at 100%. If they were hedged at say 90% they would have cleared a cool $480 million over the last 4 years in addition to their investor fees. Barclay’s affection for VXXB might be understandable after all.
VXXB is a dangerous chimeric creature; it’s structured like a bond, trades like a stock, follows VIX futures and decays like an option. Handle with care.
This article was originally published on Six Figure Investing. For more Six Figure Investing articles by Vance click here.
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