Justin Young I September 25, 2017
A highlight of last week’s CBOE Risk Management conference in London was a presentation by Nick Cherney on the design and trading of volatility Exchange Traded Products (ETPs). Mr. Cherney has quite the background. He is the co-founder of VelocityShares, responsible for the development of the most popular inverse VIX ETP (XIV) which sits at $1.46BN in AUM, and now heads the Exchange Traded Products business for Janus after VelocityShares was acquired by them. While the presentation was geared toward institutional investors, the uptick in retail interest for VIX related products makes his analysis and presentation increasingly important to both advisors and retail investors.
The presentation began with an insightful overview of the current volatility ETP market, including the exponential growth in VIX ETPs. VIX ETPs now account for more volatility exposure (or Vega ) being traded than do options on the S&P 500 – a surprising development to those with long histories trading S&P 500 options in the institutional market. Importantly, this highlights a structural shift in the volatility market from large institutional trading desks to a more dispersed retail dominated ETP market.
While interesting to hear, this shift from institutional to retail products elicits the need for retail education. For one, VIX ETPs have complex payouts and it is important for investors to understand both how the products are valued and, importantly, how their exposure to volatility may change over time. This is particularly true of inverse products like XIV that reset daily – that is to say it rebalances its portfolio everyday on the close to maintain its inverse exposure to the VIX futures. The reason for a daily reset is simple. If the fund earns a return - whether positive or negative - it must reset its exposure to maintain the correct multiple to its ever changing asset base . This daily rebalance means the products can exhibit a type of convexity - effectively meaning they become ‘less short’ or ‘more long’ Vega as implied volatility rises, and visa versa when it falls. This is an important feature to understand when considering inverse VIX ETPs. As we can see in the following chart, during periods of large volatility moves, a daily resetting inverse product like XIV may perform quiet differently to a static short position in VIX futures.
Source: Janus Henderson
As an example, imagine one held a long position in XIV and volatility were to rise. In this case the product would likely fall in value, and at the same time its daily rebalance would cause it to reduce its short Vega exposure at day end – in practice buying back some of the VIX futures it is short. On the other hand, a short position in VIX futures, or even an unleveraged long VIX ETP, would similarly change in value during a one-day volatility spike, but would not be subject to a rebalance, and therefore maintain a static Vega exposure.
This deleveraging of inverse VIX ETPs during a vol spike and their re-leveraging during vol declines can account for some surprising results through time. We can estimate that during the volatility in the fall of 2011, an outright short of a long VIX ETP like VXX could have suffered a massive 188% loss, while a long position in a daily resetting inverse product like XIV may have lost 74% of its value. On the flip side, in the significant decline in volatility we saw after the 2016 US presidential election, daily reset inverse products returned 70% while an outright short of the long products returned just 45% .
The presentation also addressed the gap risk of inverse VIX ETPs . There has been a lot of interest from analysts recently – including us at Invest In Vol - about the potential for inverse products like XIV to fall to zero during an extreme market move. Firstly, this is a fair concern and there is real risk that market conditions could cause inverse VIX ETPs to hit zero and evaporate. However, for this to happen, the VIX futures on which the ETPs are based would – in the case of XIV – need to rise by at least 80% in a single day.
These conditions are indeed rare, and would have perhaps occurred last on October 19, 1987 when the SPX fell more than 20% and the VXO Index (the old VIX index popular at the time) spiked up more than 300% on Black Monday. If the futures had existed back then it as at least possible that they could have seen more than an 80% rise and products like XIV would have went to zero. Black Monday was of course extreme, and in fact there have been only 32 days in the last 30 years where the VIX or VXO moved more than 30%.
A scenario in which an inverse product may lose most or all of its value is if the SPX experienced a very large downward move while the VIX was at a very low level. The data presented graphically below indicates that this is however far from common, and in fact there are actually no instances of SPX declines larger than 4% occurring while the VIX was below 15. That said, we are currently in the midst of the second longest bull market in US history and experiencing VIX levels below 10. Thus, while rare, the current economic climate could potentially be ripe for another adverse scenario.
Source: Janus Henderson. As of August 29, 2017
Furthermore, to impact the ETPs, large moves in the SPX and VIX would also have to be captured not only by the front month VIX futures but also the second month VIX futures. Tellingly, the historical blended portfolio of VIX futures that the inverse ETPs hold has tended to capture only about half of the move in the VIX Index, and, at extremely low VIX levels, this capture appears to have been even lower .
Source: Janus Henderson. All data for VIX moves over +10%. As of August 29, 2017
But regardless of the one day gap risk that one assigns, drawdown risk in short vol ETPs can be extreme, and managing this potential drawdown is as important as seeking returns. XIV, for example, has experienced a monthly max drawdown  of over 70% since its inception and has lost more than 5% in a single day over 140 times . The presentation proposed several approaches for managing this risk, including a strategy of dynamically allocating to short vol ETPs at opportune times.
The presentation makes a very important point here. VIX ETPs were designed as trading vehicles that offer broad access to a market previously dominated by institutional trading desks. But as trading vehicles, these products are not designed to be bought and held, but rather to be used for tactical allocation or as a hedge. The sponsors and issuers of the ETPs make this very clear in their prospectuses, but this fact is often forgotten after strong, sometimes unidirectional, runs up like we saw in the inverse VIX ETPs in 2016. Instead, investors may consider allocating to an actively managed volatility strategy that utilizes these VIX ETPs.
At Invest In Vol, we have created an investable solution for clients interested in volatility investing. Our Balanced Volatility strategy combines three unique volatility strategies to realize the benefits of strategy diversification and strives to enhance returns from volatility investing while reducing drawdowns and ultimately improving risk-adjusted metrics.
 Vega is a term used to express a financial product’s exposure to implied volatility. For a more complete description on Vega and relevant examples, please click here.
 For a more complete understanding of the nature of inverse and leveraged products, please click here.
 Bloomberg, Janus Henderson. As of August 29, 2017.
 Gap Risk is defined as the risk associated with the price of a security changing with no trading in between.
 Bloomberg, Janus Henderson. All data for VIX moves over +10%. As of August 29, 2017.
 For a more in depth definition of Max Drawdown along with examples, please click here.
 Data Source: Interactive Brokers 11/30/2010 – 07/27/2017. XIV is the VelocityShares Daily Inverse VIX Short-Term ETN which provides -1x leveraged exposure to an index comprising first- and second-month VIX future positions with a weighted average maturity of 1 month.
This is not, and should not be considered investment advice. Investing involves risk, including the possible loss of principal. Carefully consider the Strategy's investment objectives, risk factors, charges and expenses before investing. This Strategy is actively managed and there is no guarantee investments selected and strategies employed will achieve the intended results. Strategy is subject to change.
This information has been provided by Invest In Vol and is the author's interpretation of a presentation given to institutional investors at the 2017 CBOE Risk Management Conference in London . All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The views and opinions expressed are those of the portfolio manager at the time of publication and are subject to change. There is no guarantee that these views will come to pass. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. Investments are subject to change without notice.
For a more complete disclosure please visit www.investinvol.com/disclosure.