"Just about everything of consequence comes from black swans; ordinary events have paltry effects in the long term." - Nassim Taleb
Nassim Taleb is an economist and philosopher with an idiosyncratic outlook on life. In the early part of his career, he spent years as an options trader on Wall Street. Taleb brought a unique perspective to his job in that he had a very healthy respect for randomness. He challenged the academic theory that stock market returns follow a normal distribution, and postulated that extreme events were more likely to occur than what the options market was predicting. He became independently wealthy on Black Monday in October 1987 by making a then unthinkable bet that the market could sell off by such a large amount over such a short period of time. He published his first book, Fooled by Randomness, in 2001, and followed it with his now infamous book, The Black Swan, in 2007, where he explained his views on the impact of highly improbable events on various aspects of life. Taleb's second major financial fortune was made during the financial crisis that began in 2007, when he again made successful bets on highly improbable events.
Taleb now spends most of his time writing and speaking about his unique perspective and its impact on society. In his latest book, Antifragile: Things That Gain from Disorder, Taleb argues that we should strive to create a society and economy that grows stronger when stressed. He gives the example of the human body as it relates to bone density and muscle growth. Things that are "antifragile" actually grow stronger with stress and volatility, as opposed to things which are robust (impartial to stress) or fragile (hurt by stress). In a recent CNBC interview, Taleb expounds upon this exact topic.
Several months ago, we wrote an Insight on a volatility ETP, which we believe has "antifragile" characteristics. As a recap, the iPath S&P 500 Dynamic VIX ETN (XVZ) is a relatively new product that attempts to capture upward spikes in volatility while hedging the cost of maintaining a long volatility position during calm markets. It is designed to, in essence, "tread water" during low volatility markets, typical of rising stock prices, and generate the lion's share of returns during periods of stress, typical of falling stock prices. In this way, the payout function looks something like a stair step where long periods of flat returns are punctuated by large upward spikes during periods of market stress.
Through the summer of this year, which marked the one-year anniversary of the product, XVZ had done a fairly good job capturing a portion of the large VIX spikes while treading water during calm periods in the market. But then in September of this year, it started a slow and steady decline from its mid-50s trading range to around 47, where it stands today. The reason for the decline is due to two things 1) falling VIX prices and 2) a flattening of the VIX futures curve. The first factor is easy enough to understand -- any product that has a long volatility bias like XVZ will not fare well when volatility is falling. The second factor is a bit harder to understand, so we will unpack it in more detail.
As touched upon in our previous post, linked above, XVZ dynamically allocates exposure to VIX futures based on the shape of the futures curve. Under normal market conditions, futures will trade at a premium to the spot price of the VIX index. The premium increases as the time to maturity increases, but by a diminishing marginal amount. This creates a term structure that is steep in the front end of the curve and much flatter in the back end. This premium can be thought of as a "risk premium" for being long volatility. This risk premium ends up being an additional cost to maintaining long exposure to VIX futures under normal market conditions. As an example, let's say the VIX is trading at 18, and the three month futures contract is trading at 21. If one were to purchase the contract, hold it to maturity, and see no change in the price of the VIX, the futures contract would expire at 18 in three months. Even though the underlying index broke even, the investor in the VIX future lost 14% ([$21-$18] / $21) of their investment. During elevated volatility regimes, the futures curve will flatten or even invert as the price of the futures reflects the high probability of the VIX price to fall and mean revert. When the curve is flat or inverted, there is no cost to maintaining VIX exposure via futures.
XVZ shifts its allocation to VIX futures based on the cost of maintaining the exposure. When the curve is flat or inverted, it is 100% long volatility. As the curve gets steeper and steeper, it tries to offset the cost by shorting the front end of the curve, which is the steepest (e.g., risk premium evaporates the fastest) while still maintaining long volatility exposure to the back end of the curve, where the shape of the curve is a bit flatter. During these volatility regimes, the strategy will always have more exposure long in the back end than it has short in the front end of the curve in order to maintain a net long volatility position. Because there is more exposure to the back end of the curve than the front end, the strategy becomes susceptible to the curve flattening. The chart below shows the average premium that 5-6 month VIX futures trade at versus the front month VIX futures contract. The shaded regions represent high volatility regimes where the VIX was north of 30.
When the VIX futures curve flattens, the front end of the curve is either rising faster than the back end, or the back end is falling faster than the front end. The first scenario is what happened between March and May of this year, when the VIX moved from a low of around 14 to a high just over 26, and the premium plotted above went from 46% down to 20%. In other words, the front month futures moved up more than the 5-6 month futures, so the premium was reduced and the curve flattened. XVZ was hurt more by the flattening of the curve than it benefited from the rise in the VIX, and ended up losing around 5% during this period. The second curve flattening scenario is indicative of what we have seen over the past several months. Since the end of August, the VIX has been range bound, trading between 14 and 19, while the futures curve has flattened with the premium plotted above, falling from 44% to 29%. In other words, the 5-6 month futures fell more than the front end. Without the benefit of a rising VIX, XVZ bore the brunt of this flattening and fell 15%.
Obviously, we are not pleased with XVZ's recent performance, but we understand why it has happened. I had the pleasure of attending a roundtable discussion hosted by iPath on this product a couple months ago. During the discussion, I asked whether or not they had tested different rules based strategies to protect against curve flattening. The answer was that they had, but all of them involved a reduction or elimination of the net long volatility bias, which is the foundation of the XVZ strategy. In the end, they decided it was better to have a product that goes through painful times like one we've recently experienced, but maintains its objective as a hedging instrument to "risk off" environments. To put the recent slide in perspective, another iPath product (VXX), which maintains a long volatility position in one to two month VIX futures, has lost twice as much over the same time period. The other advantage of having XVZ in the portfolio is that it provides a level of insurance, which allows us to take on more risk in other parts of the portfolio. So even though XVZ has lost money over the past several months, other investments in the portfolio have benefited from the low volatility environment. Lastly, now that the shape of the futures curve is closer to the average post credit crisis, normal volatility regime (VIX < 30) of 24%, we don't expect the flattening headwind to be as strong as it has been over the past several months.
We still believe XVZ has a critical role to play in our Diversification 2.0 portfolio methodology. Slides similar to the one we've recently experience are not out of the norm, and are to be expected with any type of hedging vehicle. One of the things that has made Nassim Taleb such a great investor is his uncanny willingness to lose small amounts of money the majority of the time when his long-shot option bets expire worthless in order to collect a huge windfall over short, punctuated periods of time when the "Black Swan" finally hits. Looking back at Taleb's investment career, there were 20 years between his two highly improbable, windfall returns. It is this type of patience that makes Taleb truly unique amongst the investment community. We see XVZ as having similar characteristics to Taleb's strategy, and therefore, believe it demands patience and a long time horizon in order to prove its investment merit.
Disclosure: I am long XVZ.
Additional disclosure: Transparency is one of the defining characteristics of our firm. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments or its principals. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.