VXX’s methodology rolls exposure in a market with high levels of contango which means that roll yield is almost always negative.
Based on similar rises in the VIX since 1992, there’s about a 70% chance that we will see volatility drop over the next month.
Given that the VIX has hit a 1-month high, there’s also about a 70% chance that it’ll fall over the next month from here.
Today was a good day for the holders of the iPath S&P 500 VIX Short-Term Futures ETN (VXX) with shares increasing by nearly 6%. While these returns certainly did make a few traders’ week, I believe it’s important to keep perspective on exactly what VXX does as well as its long run returns. Put simply, in my opinion, VXX is an instrument of wealth destruction over lengthy time periods as evidenced by its year-to-date decline of nearly 54%. As we’ll discuss in the following sections, not only is VXX based on a badly-designed methodology in my opinion, but the mean-reverting nature of volatility indicates that we’re probably going to see a drop in VXX soon.
A Bad Design
Let’s talk about VXX. Specifically, let’s talk about exactly what it is that you’re trading when you buy or sell the ETN. To understand VXX, we need to look under the hood at the index which it tracks: S&P 500 VIX Short-Term Futures Index.
In my opinion, S&P Global’s Short-Term VIX Index is a very poorly designed index which investors should seriously consider entirely avoiding. This is a very strong statement, but I believe an impartial look at the underlying data will push you towards a similar conclusion.
So let’s start from the beginning. The short-term VIX index looks to give a weighted-average exposure to VIX futures of about 30 days into the future. It does this using the front two months of VIX futures contracts. This sounds nice on paper, but if you actually think through the methodology, this tangibly means that on a daily basis, the index is required to sell a portion of the front-month contracts and shift that exposure into the second-month contracts. In other words, you start a month almost 100% in the front-month contract and end a month with around 100% in the second-month contract.
As you can see from the wonderful VIX Central, the differential between these two months is generally about 10-15%.
So to recap: VXX is rolling exposure into a contract which is priced roughly 10-15% above the front-month VIX contract in such a way that near the end of a month, basically 100% of the exposure of the ETN is in the second contract. What could go wrong? Two words: roll yield.
There’s a general tendency in financial markets in which prices in the back months of a futures curve tend to move towards the front of the curve as time progresses. This tendency practically means that the 10-15% average price difference between VIX contracts will fall up into the expiry of the front-month contract. These are traded contracts, so we can’t precisely know the price path of this differential, but in general, the relationship plays out in almost every month of the second-month contract falling towards the first month contract.
This tendency in and of itself means that rolling long exposure in VIX markets would really hurt. VIX futures are almost always in contango which means that roll yield is almost always going to be negative, no matter how you slice it. But if you recall, the index VXX follows has that funny “30-day weighted-average exposure” thing. This means that the effects of roll yield are dramatically amplified as a month progresses.
To understand this, there’s another general tendency of roll yield to consider: it tends to be most dramatic at the front of the curve. You can use a variety of statistics to make this case, but a simple mental exercise proves the point just as well. Let’s say that you think the VIX is going to be higher in the future. This is the general assumption in the VIX markets which results in a VIX futures curve that looks something like this most of the time.
If time progresses and the VIX hasn’t rocketed higher as anticipated, at some point, the elevated levels of the VIX will fall towards the front-month VIX price and this “uncertainty premium” will evaporate. The effects of this are most keenly felt in the front contracts because this is the point at which the uncertainty premium becomes more certain (if you’re familiar with options, think theta/time decay and you’ve got the concept).
Since the front contracts see the most “time-decay” as uncertainty becomes more certain, the level of contango will contract most sharply in these front months. VXX’s methodology means that right as theta decay/time decay is putting the most pressure on futures prices for the VIX, you’ll be putting all of your eggs into the second-month basket. In other words, with the VIX Short-Term Futures Index, you’re doing exactly the wrong thing at precisely the wrong time.
The impact of roll yield is not-immaterial. It is almost the entire determinant of long-term returns of the methodology. For example, here is the last decade of returns for the index which VXX directly replicates.
VXX’s methodology has delivered an annualized return of -53% per year for the past decade. Again, so there’s no ambiguity here: if you buy VXX, you are buying these returns. If you thought that the 54% year-to-date drop in VXX was abnormal, think again – this is par for the course in this ETN and only slightly above average. If VXX was around over the last decade and you put $100,000 in it, you would now have $50 left of your trading capital.
Based on a near-constant roll loss in VXX, I can only recommend shorting or avoiding the ETN. However, specific volatility factors strongly indicate that we’re going to see lower levels of the VIX over the next few weeks giving further tailwinds to a short trade.
Let’s start with some basic statistics. Over the past week, the VIX has risen by around 4.5 points. Since 1992, there have been 334 one-week periods in which the VIX has risen by this much or more. Of these periods, only 30% witnessed a higher level of the VIX one month later. Also of these similar cases, only 33% were higher over the next week. In other words, given that we’ve seen a VIX pop, the odds very strongly suggest that we will see an immediate (and lasting) VIX drop.
We can frame this up in a lot of different ways. For example, over the last week, we’ve made a fresh 20-day high in the VIX. Historically speaking, when the VIX hits a fresh 20-day high, the last 27 years of market data would suggest that we’ve only got about a 32% chance that the VIX will be higher 1 month from now.
The market statistics are fairly conclusive at this point. Given that the VIX has popped, there’s a very strong probability that it’ll drop from here. When you combine this with the average decline of 54% year due to roll yield, shorting VXX makes for a strong play at this point.
VXX’s methodology rolls exposure in a market with high levels of contango which means that roll yield is almost always negative. Based on similar rises in the VIX since 1992, there’s about a 70% chance that we will see volatility drop over the next month. Given that the VIX has hit a 1-month high, there’s also about a 70% chance that it’ll fall over the next month from here.
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.