Stuart Barton, PhD, CFA I September 21, 2018
In October last year, I published an article asking whether daily inverse VIX products might offer a supplement, or even an alternative, to broad equity allocations. That article proved extremely popular, receiving tens of thousands of views and sparking a still ongoing debate online. If you haven't already read that article, I invite you to read it here.
In that article, I investigated the VelocityShares Daily Inverse VIX Short Term ETN (Ticker: XIV) as a replacement for the S&P 500 Total Return Index (Ticker: SPTR) and found that as little as a 20% exposure to XIV appeared to offer investors similar exposure to a 100% allocation to the SPTR. I pointed out that a 20% exposure to XIV with the balance in cash equivalents might be considered a more palatable risk by some investors, given that extreme falls in the stock market could only ever lose the investor their fractional 20% exposure.
Furthermore, with the impressive performance of XIV in 2016 and 2017 (81.20% in 2016 and 187.57% in 2017 according to Bloomberg), a Stock Replacement Strategy (SRS) of 20% XIV and 80% cash equivalents would have performed very well, returning 20.30% in 2016 and 37.51% in 2017.
However, since that article's publication in October 2017, XIV suffered a massive loss and was retired in February 2018 by its issuer Credit Suisse (NYSE:CS). After a 4.1% correction in the SPX on February 5th and in what looked like a flurry of after-hours trading between 4 and 4:15 p.m., the XIV lost more than 96% of its previous day's value, in what appears to have been the result of a complex technical facet of XIV itself. I have written extensively on the reasons behind the XIV collapse, but for a popular and relatively straightforward article, I recommend you start here.
So, given XIV lost 96% of its value in a single day and recovered only very slightly before being retired by Credit Suisse, any exposure to XIV has clearly performed very poorly this year, and you'd expect a stock replacement strategy using XIV - or one of its similar competitors - to have also performed very poorly. Well perhaps, but let's take a closer look at the numbers.
For the purposes of this analysis, I will use the daily inverse of the index on which the VIX ETPs like XIV are based - the S&P 500 Short-Term Futures Index (Ticker: SPVXSP). Before its retirement, the XIV sought to deliver the daily inverse returns of the SPVXSP index, and for consistency, during the period of its retirement, I'll use it for this illustration.
Now let's assume an investor had a 20% allocation to XIV (or the inverse of SPVXSP index) and an 80% allocation to cash on the close of February 5th. As I described in my earlier article this had, in the past, demonstrated a reasonable proxy to a 100% allocation to the S&P 500 Total Return Index (Ticker: SPTR). After a volatile day on the 5th and a broad fall in equity prices, the SPVXSP index jumped 96.12% and the XIV that tracked its daily inverse performance lost a similar amount. A huge one-day loss by any measure! With a 20% allocation to XIV, this would have represented a 19.22% single-day loss to the SRS, leaving a portfolio value of just 80.78% of its previous day's close on February 2nd.
Now a 20% single-day loss is obviously substantial, and many investors would have been tempted to abandon the strategy and return to cash. However, let's imagine the investor was able to stick to their strategy of allocating 20% to short volatility and 80% to cash, and instead of running to the hills and returning to cash, rebalanced their portfolio at the close back to the 20% short allocation to SPVXSP as prescribed by the SRS. As volatility declined in the days that followed, the portfolio would have started to recover. On February 6th, for example, when the SPVXSP index fell 25.95%, the 20% short volatility allocation would have gained an impressive 5.19%, bringing the SRS portfolio back to 84.97% of its February 2nd closing value. Continued adherence to the strategy each day - rebalancing back to 20% on each close each day - would have resulted in the portfolio recovering to an impressive 91.45% of its Feb. 2nd value in just six months - by the close on September 5th. Not too bad for a short volatility strategy over the six months that included the largest VIX spike in history!
SPVXSP data from Bloomberg
Implementation may have been challenging. For one, the XIV product was retired on February 20th, and its cousin product, the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) had its exposure to SPVXSP cut in half on February 27th. These events left investors with no 1x daily inverse product to trade.
However, exchanging XIV for SVXY and increasing exposure to regain 1x daily inverse exposure on February 28th could have overcome both of these challenges - but not without its own complications. While a doubled (40%) exposure to the deleveraged SVXY would have offered an investor similar exposure to the SPVXSP index as did a 20% exposure to XIV before its retirement, a 40% exposure to SVXY would, in theory, have risked 40% of a SRS portfolio and not just 20%. While some would claim that it is less likely that a deleveraged SVXY will fall to zero, that possibility still exists and has to be considered.
Another approach could have been to take a daily short position in the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX). The VXX offers investors 1x long exposure to the SPVXSP, and a daily rebalanced short position could have a very similar return profile as a long position in a product like XIV. However, like the increased risk of holding a 40% long allocation to SVXY, a 20% short allocation to VXX would risk the investor significantly more than the 20% allocation proposed in the SRS. If, for example, VXX was to triple in value during a volatility spike, not only would the investor lose the 20% they had allocated to short volatility but also lose a further 20%, and the losses could be undefined if the VXX continued to rally. As a stock replacement strategy, therefore, this approach just doesn't make sense.
Another approach might be to have used the VXX with stop orders. If each day when the investor rebalanced their short VXX position, they also entered a buy stop order at exactly double the VXX's previous closing price, the order would offer some, but not total, protection to an extreme spike in volatility. I say some because of the inherent 'best efforts' nature of stop orders, that after triggered will buy back the short VXX position at the 'market' price. If volatility spikes and the market for VXX rises quickly, the final cost of covering the VXX short might significantly exceed the stop order price and leave the investor with a loss much greater than the 20% allocation. This doesn't even factor in the cost to borrow shares of VXX which can greatly eat into returns.
So, while a short volatility SRS may have performed reasonably given the circumstances, its continued implementation this year would have been quite challenging. There are, of course, more sophisticated implementations using options that I haven't gone into here, but all of these introduce a further complication including the increased difficulty of daily rebalancing, shifting option deltas, and an unwanted exposure to the implied volatility of the underlying Exchange Traded Product - effectively an exposure to the volatility of volatility.
Conclusion
Some short volatility investment strategies, including the SRS described above, seem to have performed better than most would have expected this year. However, if February 5th has taught us anything it should be that volatility products are complex and should be handled with care. Adding volatility to a portfolio as a diversifier or a replacement for equities comes with increased complication and their implementation may require more work than many investors are able to take on. For example, daily rebalancing a portfolio of short VXX every day on the close, while also entering daily stop orders is probably not practical for the average investor.
But this doesn't mean that inverse volatility returns are off the table for the average investor, or that they have become the sole domain of sophisticated hedge funds. Registered Investment Advisers (RIAs) offer managed accounts in these products and take care of all the day to day maintenance that the strategy requires. Whether it is an inverse volatility SRS, an alternative investment or a hedge fund replacement, a professionally managed account with a specialist volatility RIA might make the complex process of capturing volatility returns more accessible.
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