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Summary

  • Volatility declined, yet short volatility ETFs (SVXY, XIV) lost value in Q1. This underperformance comes from daily exposure adjustment, not from the fundamental value of volatility (VIX Index).
  • This article will help explain the recent performance and the mechanics behind it.
  • Neutralize the performance drain using a rule-based trading strategy.
  • Finally, two scenarios outline how performance could once again be driven by fundamentals.
  • Investment opportunity: Now is not the time. Either wait for a large move to create an investment opportunity, or trade around an existing position in small amounts.

Short volatility products have not delivered in the first quarter. For investors, it is important to understand that this negative performance is derived not from the fundamental value of volatility, but instead from a property common to all short investment vehicles: the cost of daily exposure adjustment. This article presents a performance attribution, explains the mechanics behind the recent price decline, and details a trading strategy on how to neutralize the performance drain. Finally, two scenarios outline how performance could be once again be driven by fundamentals -- i.e., the value of volatility.

A volatility spike might create the opportunity to enter a larger position. Until then, the performance drain on an existing position could be mitigated through an active trading strategy in small quantities.

Performance Review: A Disappointing Start to the Year

Short volatility products such as the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) and the VelocityShares Daily Inverse VIX Short Term ETN (NASDAQ:XIV) have greatly underperformed in the first quarter, posting a return of -6.26%. A moderate increase in the S&P 500 Index and even a small decline in the VIX suggest that this should not have been a dismal quarter for short volatility strategies. Actually, it wasn't: A short position in the April 2014 VIX future would have generated a gain of 8.2% from Jan. 2 to March 31, 2014. The S&P 500 VIX Short-Term Index MCA, the benchmark of the aforementioned short volatility products, lost 2.4%. Shorting the index should not have resulted in a loss, one should think. The table I've created below summarizes Q1 performances:

Performance From Jan. 2 to March 31, 2014

S&P 500 Index (total return)

2.20%

S&P 500 VIX Index

-2.46%

S&P 500 VIX Short-Term Index MCAP

-2.40%

ProShares Short VIX Short-Term Futures ETF

-6.26%

VelocityShares Daily Inverse VIX Short-Term ETN

-6.26%

SVXY, XIV underperformance vs. inverse benchmark

-8.66%

What Cost So Much Performance

Short volatility ETFs and ETNs seek to provide a daily return of -1 times their benchmark index. This requires the product to adjust its exposure to VIX futures every day. Rising VIX futures cause the net asset value of the ETF to decline; less futures are need to match the ETF's assets and the fund buys back some. The opposite is true when VIX futures fall. This effectively results in buying high and selling low. The chart below shows how the short ETF underperforms when the market changes direction. Note that the daily returns of the underlying and the short strategy match, while the two-day returns differ.

Click to enlarge images.

Source: Created by the author using my own calculations.

The performance drain is more pronounced when:

  1. returns whipsaw (positive and negative days alternating - the absence of a trend)
  2. volatility (of the VIX) is higher

Unfortunately, we experienced both in Q1. The S&P 500 VIX Short-Term Index MCAP followed a pronounced whipsaw pattern: In 61% of all days it moved in the opposite direction of the previous day, much more than the approximately 50% we would assume in a neutral market. The benchmark's realized quarterly volatility rose from 28.6% to 34.9% (annualized).

The chart below shows how this eats into the performance -- for comparison the benchmark is displayed on inverted scale. The SVXY (red line) initially tracks its benchmark (in purple), but then a gap between the two gradually widens. Still, all daily returns match those of the benchmark. While fees also have a negative effect on performance, they play a comparatively small part with 0.95% p.a. (0.24% per quarter).

Source: Created by the author, using data from Yahoo Finance and the S&P Dow Jones Indices website.

A Rule-Based Counter-Strategy

To neutralize the buy high/sell low effect inherent in the product, an investor (or speculator) would have to systematically do the opposite and buy into the ETF whenever it falls in price, and sell some whenever it rises. As a simple rule, twice the performance of the ETF should be bought or sold in size. For example, should the price of the ETF fall by 2%, the position in the ETF would have to be increased by 4%. Of course, this strategy requires (potentially a lot) of extra capital available for investment -- especially when prices are falling. Additionally, transaction cost might limit the frequency and size of incremental trades. Further strategies are presented on p. 10 of ProShares' brochure on the subject.

A Change in Market Regime Is Needed

How can fundamentals -- i.e., the larger price movements of the VIX and its futures roll yield, again dominate the returns of short volatility products? The ultimate fundamental driver for volatility products is the S&5 500 Index. A sharp drop in the S&P 500 Index would once again make market movements dominant (in a negative way at first, but later positive when volatilities come down from crisis levels). Alternatively, a sustained strong rally might reinstate the steeper and more stable term structure we have observed during 2013, providing steady returns from the futures roll.

The current situation does not present itself as an investment opportunity. Investors interested in entering or adding to an existing short volatility position through an ETF might find it appropriate to sit on the sidelines until volatility spikes up (as a rough indication: VIX around 20). In the meanwhile, trading around an existing position by buying small quantities on days the ETF declines and selling small quantities on up days might mitigate the current performance drain.

Source: Short Volatility ETFs: Underperformance, But Not Due To Fundamentals