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A surprising thing occurred several months ago as I performed a performance screen on ETFs and ETNs. Out of 1300 candidates, the top performing exchange-traded vehicle over the previous fifty-two weeks had been Credit Suisse's Inverse Volatility ETN (NASDAQ:XIV), with gains of over 100%. More astonishing was that if one went back another few months, the total gains in XIV were in excess of 350%! My curiosity was peaked. Always a skeptic who believes one does not find outsized returns without a catch, I began to look under the hood of this investment vehicle.

XIV is structured to be an inverse ETN to the VIX, a measure of implied volatility for S&P 500 index options. The VIX is often perceived to be the main "fear index." On its face then, XIV would appear to be a vehicle well-suited to investors who, for whatever reasons, believe that calm and complacency will pervade markets. However, a close examination of the structure of XIV and market history since its inception make it clear that the instrument has benefited from an unsustainable and ongoing decline in volatility as measured by the VIX. There are actually three different elements of XIV that act together when volatility is exceptionally low which ephemerally juice its returns above what one would expect for an unleveraged inverse-VIX instrument. But the flip side is that when the VIX returns to its typical historical levels, or actually spikes higher, XIV will likely get pummeled, beyond what one would expect for an unlevered exchange-traded instrument. Accordingly, investors should heed the repeated warnings provided in the ETN's prospectus stating clearly that this is an instrument intended to be used as a short-term (ideally intraday) trading vehicle, and the investors holding XIV for long periods of time should expect to lose money.

Sadly, the impact of this article will be much less salient than it would have been when the bulk of it was written towards the end of last week. As I write this, XIV is down 17% for the day (including after-hours trading). Nevertheless, it may serve as a warning to investors tempted to pick up what may be perceived as a winning ETN at a discount. Let us now look at each of the three ways in which XIV is structured to produce exceptional returns when volatility as measured by the VIX is low, yet will all work to compound losses if and when volatility spikes.

First, keep in mind that the entire trading history of XIV only dates back 2 1/2 years. These 30 months have been generally halcyon times indeed for US equity markets. It encapsulates over 60% of the bull market since the March 2009 lows. The S&P 500 is up more than 40% in those 2 1/2 years. It should come as little surprise that the VIX, until April 15th, has been trading at low levels not seen since early 2007. Moreover, the further the VIX drops below its historical norm, the greater its contango in the future markets as more investors (correctly) bet on the VIX's likely reversion to the mean (for an overview of how contango has impacted XIV's price). So the question is, how much longer will near record low levels of volatility continue in the markets? Market history indicates the XIV is running on borrowed time.

Second, when the VIX finally does spike to extreme levels, backwardation will almost certainly enter the VIX futures markets, dealing a lethal double blow to the XIV. Why would we expect this? For the same reason contango exists when the VIX trades at exceptionally low levels - reversion to the mean. To see how this might play out, one only need look at what happened to the XIV between early July and late November of 2011. The S&P was not even down 15%. The VIX, however, spiked 115%. Now one might guess that the XIV, being an unlevered inverse ETN to the VIX, would be down around 55%. Actually the losses in the XIV were 75%! Given the magnitude of the losses in XIV it should come as no surprise that VIX futures market quickly switched from contango to significant backwardation.

Third, daily rebalancing will be a stiff headwind for anyone long XIV for any significant period of time, which only gets worse with any increases in volatility. ETNs using daily rebalancing suffer from price decay due to volatility. This phenomenon is well documented with levered funds. But as an inverse ETN employing daily rebalancing, volatility loss applies to XIV as well. Credit Suisse makes this plain in its prospectus for it VelocityShares ETNs, of which XIV is one:

Daily rebalancing will impair the performance of each ETN if the underlying Index experiences volatility and such performance will be dependent on the path of daily returns during the holder's holding period. At higher ranges of volatility, there is a significant chance of a complete loss of the value of the ETNs even if the performance of the applicable underlying Index is flat. The ETNs are designed as short-term trading vehicles for investors managing their portfolios on a daily basis. They are not intended to be used by, and are not appropriate for, investors who intend to hold positions in an attempt to generate returns over longer periods of time. [Emphasis original]

Credit Suisse goes on to show what would happen to investor returns in different volatility environments. It is no surprise that investors experience little decay when volatility is exceedingly low, as has been the case for the better part of XIV's existence. But Credit Suisse provides an example with the assumption that the VIX declines 98.89% over the life of the fund (imagine the VIX at .15!!!) Yet due to high annualized volatility XIV returned -27.16% to its investors. Granted that is an extreme case. But any substantial pick-up in volatility would cause price decay for XIV to become an issue.

The effects of a day like April 15th perfectly manifest this point. After a 17% drop, the ETN must realize losses that day in order to maintain its fixed leverage ratio. Someone naive as to the effects of volatility loss might think that a day like April 15th is offset by a day where the ETN would increase 17%. That would be incorrect. If XIV is at $25 and drops 17% to $20.75, a 17% increase only takes the XIV to $24.28. To get back to its original $25 level, XIV would need to go up by 20.5%. Thus you would have 3.5% volatility loss for just one day. Any extended period of heightened volatility just compounds this loss.

Aside from the three points articulated above, it should also be a red flag to investors (as opposed to traders) when the prospectus for a fund expressly states that this is not a vehicle intended to be profitable over longer holding periods. Clearly investors ignoring such an admonition do so at their own significant peril. Again, from Credit Suisse:

The ETNs are only suitable for a very short investment horizon. The relationship between the level of the VIX Index and the underlying futures on the VIX Index will begin to break down as the length of an investor's holding period increases, even within the course of a single Index Business Day. The relationship between the level of the applicable underlying Index and the Closing Indicative Value and Intraday Indicative Value of the ETNs will also begin to break down as the length of an investor's holding period increases. The ETNs are not long term substitutes for long or short positions in the futures underlying the VIX Index. Further, over a longer holding period, the applicable underlying Index is more likely to experience a dramatic price movement that may result in the Intraday Indicative Value becoming equal to or less than twenty percent (20%) of the prior day's Closing Indicative Value. Upon such an event, your ETNs would be subject to acceleration and you will likely lose all or a substantial portion of your investment. The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment. [Emphasis original]

Setting aside the efficacy of its intended use, XIV is designed to be a daily trading vehicle; nothing more, nothing less. However, given its spectacular gains in the last 18 months, it is not surprising that it has attracted a great deal of attention from investors who believe they may have stumbled upon the Holy Grail of investing. Indeed, XIV has had three unbelievably strong tailwinds at its back powering staggering gains. First, volatility has fallen to six year lows. Second, contango has juiced recent gains as futures contracts on the VIX can be shorted at premium prices and covered after prices converge lower. Finally, excessively low volatility has meant that XIV has not suffered from the price decay that would occur in a normal environment. Yet maintaining XIV as even a short- to medium-term hold strikes me as a classic "picking up nickels in front of a steam-roller" maneuver by investors, as a day like April 15th should make clear.

Is there any place in an investor's portfolio for XIV? I would say possibly yes, but only in the exact opposite situation that existed in the markets up through last week. July 2011 is an example of such a time, where the VIX traded at some extreme levels (40+) and was also in a state of backwardation (thereby further eroding XIV price). A condition like that is unlikely to persist for a long time, and the risk-reward profile of XIV becomes much more attractive. But once markets calm down, investors should exit XIV. Even under this condition, however, investors must realize that in the short-term, XIV could suffer ongoing significant losses, as we have seen the VIX go as high as 80. As such, investors would have to possess the intestinal and financial fortitude to dollar cost average into such declines to get the full benefit of the strategy.

Risk factors on the horizon seem to be multiplying. Economically there are threats of further Eurozone debacles as periphery states still look moribund and fragile, the possibility of a double-dip in the US, a "hard-landing" in China (possibly induced by a credit crisis) as well as potential currency wars as Japan, overtaking the US in currency debasement, leads the charge to the bottom. Geopolitically, tensions abound, with North Korea, a blow-up in the Middle East, or a conflagration with China over access to resources or trade routes all posing threats to asset markets. Finally, after a dizzying 130%+ ascent since the March 2009 lows, US equity markets might just pull back substantially under their own weight as was the case in late 2007. Any of the aforementioned threats could knock complacent investors for a loop and easily cause the VIX to double or triple very quickly. Contango would be replaced by backwardation, causing XIV to sell short futures at discounts and unprofitably cover once prices converge upward. With resumed volatility, price decay in the XIV would also magnify losses.

I feel better about taking the other side of the trade when it comes to those advocating long positions in XIV.

Source: Beware The Sweet Siren Song Of XIV