We understand this idea that if I bump a coffee cup a little bit against the side of the table, I can do that a thousand times and there's no damage…But one large shock, like dropping it three feet rather than an inch 36 times is totally different. It's not just a little worse-it's over, it's dead. Now how does that work on the antifragile side? The argument has to be, to carry it over, it gets stronger and stronger and stronger, so that in fact, the bigger the bump, the better, as long as I stay below some threshold. -- Nassim Taleb
A couple weeks ago we wrote an Insight about a fund that has "antifragile" characteristics. As a review, antifragility is a word that Nassim Taleb has coined to describe things that thrive from stress and disorder. It is more than just a state of robustness which would be considered resilient to, but not necessarily a beneficiary of, those forces. One of the examples that Taleb likes to use when talking about antifragility is Hydra, a serpent-like creature from Greek mythology that grew two new heads for every one that was cut off. Assuming a plethora of heads is a good thing, Hydra would be considered antifragile given the benefit that was derived with every beheading. This week we will look at another investment which possesses antifragile tendencies as we delve into the world of volatility investing.
The most often quoted metric of stock market volatility is the VIX Index. The actual calculation of the VIX isn't as important as understanding how it moves in relation to the stock market. It is commonly known as the "Fear Index" since it tends to spike upward when the stock market is selling off.
The direction of the VIX can be predicted with a high degree of certainty in relation to the direction of the stock market, and since the movements of the two assets are typically in opposite directions they would be consider negatively correlated. Assets that can independently produce positive long-term returns with low or even negative correlation to each other are the cornerstone of our Diversification 2.0 portfolio construction methodology.
The VIX index itself is not investable, but there are numerous investment vehicles that are tied in some way to the VIX, each coming with its own set of nuances. The easiest and most common options for individual investors are exchange traded products (ETPs), the most popular of which is the iPath S&P 500 VIX Short-Term Futures ETN (ticker: VXX). There are a variety of other ETPs that provide similar exposure such as VIXY and VIIXas well as leveraged products like TVIX.
All of these products provide exposure to short-term VIX futures that offer the most "bang for the buck" when it comes to participating in large spikes in the VIX Index. More specifically, the exposure gained through VXX and the like is akin to holding a position in the first and second month VIX futures contract. At the end of every day, the exposure is rebalanced to a one-month duration by selling out of a portion of the front month contract and purchasing more of the second month contract.
The problem with doing this is that the investor is now exposed to something called "roll cost" which is the difference in the price one receives for selling the first month contract and purchasing the second month. When the second month contract trades at a higher price than the first, a very common state for VIX futures, investors in these products incur a cost every day for the underlying exposure being rolled out of the front month and into the second month contracts. As a practical example if the front month VIX contract is trading at $20 and the second month is trading at $21, then there is a $1 roll cost of selling each contract at $20 and buying the same number of contracts at $21. This roll cost can be significant depending on the prevailing shape of the VIX futures curve as shown in the embedded table.
The end result is a return stream that is only suitable for short-term traders with detrimental characteristics for investors looking to buy and hold for longer periods of time. This is clearly seen by the large discrepancy in the cumulative return stream of the VIX index versus VXX.
To address the roll cost problem iPath launched the S&P 500 Dynamic VIX ETN (XVZ). The goal of the strategy underlying XVZ is to minimize roll cost during times of relative calm in the market when the VIX is either falling or trading sideways while being able to capture a portion of the upside when the VIX spikes during periods of market turbulence. The way this is done is by shifting exposure along different points on the VIX futures' curve. When the curve is steep and the roll cost is high, a state known as "contango", XVZ will take a short position in the front end of the curve to try to capture the roll cost while taking long positions in futures which are 4-7 months from expiration to hedge the short position and still maintain a net long exposure to large upward moves in the VIX.
On the other hand, when the curve is flat or even upward sloping (a state known as "backwardation"), the roll cost is low or even negative so XVZ adjusts its exposure to only hold long positions in the front and second month VIX futures which, as we previously stated, have the most bang for the buck when it comes to large spikes in the VIX index. XVZ has only been around for a little less than a year, but since it tracks an index with a predefined investment discipline, S&P was able to produce theoretical back-tested results which are shown in the chart below.
The key takeaway here is that XVZ is designed to more or less tread water during periods of relative calm in the markets and then participate in big spikes upward in the VIX when markets sell-off. The end result is a return stream that somewhat resembles a staircase with long periods of flat to slightly negatives returns punctuated by short periods of upward spikes that typically occur during large selloffs in equity markets. This return stream has strong characteristics of antifragility and adds meaningful diversification when combined with other assets.
As always, we want to make sure that everyone who reads this knows that this investment is not without risk. There are periods of time where the strategy can perform very poorly due to a variety of factors. One such time in the back-test was between September 2010 and July 2011 when the underlying index lost over 20%. This was primarily due to the shape of the VIX futures curve flattening while the underlying exposure was short the front end and long the back end.
Another way XVZ could fail would be if there is a change in the VIX that occurs quicker than XVZ can adjust its exposure, which only happens at the close of each trading day. A good example might have been the 9/11 terrorist attacks, before VIX products were even traded, which changed the volatility landscape dramatically during the course of one trading day. Lastly, but definitely not the only other risk, XVZ is an exchange traded note which means that investors in the product take on the credit risk of the underlying bank (Barclays Capital in this case).
Weighing the positives against the negatives, we still find XVZ to be a very attractive product and have made it a core holding in our Absolute Return asset class.
Disclaimer: We want transparency to be 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 and 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.
Disclosure: I am long XVZ.