Over the last week, the price of the VelocityShares VIX Short-Term ETN (VIIX) has continued its almost perpetual decline with shares dropping by over 8%. As seen in the following momentum table from Seeking Alpha, this drop has brought returns for the ETN into negative territory for every monitored time frame.
It is my belief that in the coming weeks and months, this long-term trend (which has virtually destroyed the wealth of long-term holders) will continue. Specifically, I believe that both roll yield and drops in the VIX itself will bring returns for VIIX even further downwards.
Let’s take a brief pause to talk about VIIX and what it actually is. In the volatility ETP space, the devil often is in the details and especially so for VIIX. VIIX is one of a few volatility ETPs which follow the most popular volatility index: the S&P 500 VIX Short-Term Futures Index. This index provided by S&P Global is very straightforward – it rolls exposure in the front two months of CBOE’s VIX futures such that the weighted-average holding period is roughly one month into the future.
If you understand the implications here, this means that as the month progresses, a greater share of the actual holdings which the index tracks are in the second month futures contract. If you’re aware of the tendencies of the futures market, this means that roll yield becomes a greater and greater source of returns as a month progresses. Given that the next expiry for VIX futures is 5 days from now, this means that almost all of the holdings are in November futures rather than the front and roll is taking a strong toll on shares of VIIX.
To understand why roll yield is such a big deal, here is a screenshot of 10 years of returns for the S&P 500 VIX Short-Term Futures Index.
That is not a typo. You are not misreading the fact that the index which VIIX tries to directly replicate has lost an annualized 52.77% per year for the last decade. To frame this up, if you had invested $100,000 into this index 10 years ago, your money would now be worth a grand total of $55 and you would have lost 99.94% of your investment. Now, understand that when you hold VIIX, you are holding something which is giving you this return. On this basis alone, I believe that investors should walk away from the ETN. However, with around $25 million still managed by the note, many are still trading this looking for upside.
The reason why this instrument constantly drops is roll yield. Roll yield arises when you hold exposure in the back months of a futures curve due to the fact that as time approaches, contracts in the back tend to approach the front. To understand this, here is the current forward curve of VIX futures.
If you were to buy VIIX right now, you would be receiving the return primarily of November VIX futures with only a touch of October futures. The tendency of roll yield says that as time progresses, contracts in the back tend to approach the front month contract price. Since November is above October in terms of price, the predominant position of the ETN held in November will generally be decreasing through time as we near expiry. This will result in losses as long as the market remains in this state (contango) – and history is pretty clear, VIX futures are almost ways in contango due to an expectation of higher volatility in the future than the present (data here).
Timing the VIX
Timing the VIX is actually pretty simple because it is highly mean reverting – buying the lows and selling the highs tends to pay out. But the problem is that the VIX is not directly investable. VIX futures which settle off of the reported VIX were created and a number of volatility ETPs track VIX futures as a way of giving exposure. But the VIX futures curve itself tends to contain a strong degree of contango and shares tend to drop as a result.
All this said, there are a few key factors which I believe suggest that now is an excellent time to short the VIX, beyond roll yield. Specifically, the first of these has to do with the recent magnitude of the spike in the VIX seen over the last few days.
Through early this week, the VIX rose by 6.3 points over a period of two weeks. Numerically speaking, when the VIX has risen this much or more over the same period time, the odds strongly suggest downside over the next month. Using the last 27 years of market data, I have created the chart below which shows the historic movements in the VIX following a jump this large or larger.
As can clearly be seen in the chart above, when the VIX increases by a similar amount to what we have seen this week, future downside in the index is highly likely. Over the last 27 years, when we have seen VIX rallies in the territory of what has been seen through Monday, the odds would say that selling VIX over the next month would result in gains about 70% of the time. These are not good odds to fade or ignore.
At present, we are in the month of October. Market participants generally worry about volatility in the S&P 500 – and generally for good reason. Volatility tends to be more volatile during the month of October as seen by the standard deviation of the average VIX per month.
October tends to be the most volatile month for the VIX and many investors believe that buying volatility in October should be a winning trade due to the general increase in the level of VIX between September and October.
This “October Effect” is present in the data, but when you examine the market data from a conditional probability standpoint, you’ll find that the effect is largely a product of the market conditions going into October rather than any specific magic associated with October itself.
Specifically, if volatility increases from the least volatile period of the year (around July) through September, there’s only a 38% chance that October will average higher than September. In other words, since the monthly average level of volatility increased from July through September, the last 27 years of market data would say that there’s only a 38% chance that October will average higher than September. Given that October’s daily VIX reading is currently averaging 18.9 (compared to September’s 15.7), this is a strong sell signal in that the data strongly suggest further lows in the VIX.
This analysis may seem a bit complicated, but the underlying principle of mean-reversion is what shines through here: when volatility increases, it tends to decrease in the future. Since September was relatively strong, expect general weakness in October.
VIIX offers direct exposure to an index which has a proven track record of eliminating wealth in the long run. Volatility has recently strongly increased which is historically followed by weakness in the VIX over the next month. The October effect is dependent on the conditions leading into October and the conditions suggest downside in the VIX.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.