VIIX: More Downside In Store For VIX Bulls
Summary
- VIIX has delivered a strong return to investors this year as the VIX has popped – but the long-run returns are against volatility bulls.
- Roll yield has historically decimated holdings of ETPs following the VIX and losses from roll yield are the natural state for VIX futures.
- It is time to take profits in VIIX and avoid purchasing at this point.
As you can see in the following momentum table from Seeking Alpha, it’s been a pretty good year for holders of VelocityShares VIX Short-Term ETN (VIIX).
If you’ve been lucky enough to have captured this upside, I suggest taking profits. If you’re standing on the sidelines, I suggest avoiding this ETN. Put simply, I am quite bearish VIIX due to a few key factors which we’ll discuss in the following sections.
Digging into the Methodology
If you’ve ever read the description of VIIX at etf.com, you’ll come across this very important comment.
In my opinion, these two caveats should be written in flashing red letters which all investors must read before purchasing the ETP. The reason why I am so adamant about this is that having discussed the VIX and VIX-related ETPs with many several individuals, I have observed that a good percentage (perhaps greater than 50%) are unaware of these two noted caveats of poor correlation as well as “vast” sums of capital “erased” for holders of volatility ETPs like VIIX. Furthermore, of those who are aware that something is amiss in the volatility ETP space, even fewer grasp exactly why volatility ETPs don’t seem to deliver. In this section, we are going to do a deep dive into the driving force behind etf.com’s commentary above. So let’s jump in.
Most investors who have been around financial markets for some length of time stumble upon the VIX at one point or another. The VIX is commonly quoted on many financial media sources and is a fairly good gauge at predicting the “fear level” in the market. At some point along the way, these investors may generate a feel or a sense for where the VIX is likely headed and look to the VIX-tracking ETPs like VIIX to place a bet on future movements of volatility.
When these investors place their bets, they may initially not notice a problem. Their investment seems to generally track the daily movements in the VIX (albeit lagging somewhat), but since their holdings are directionally moving in line with the VIX, they tend to not be concerned. However, as the days and weeks go by, long-term holders of VIX-linked ETPs start to notice a problem: their holdings are lagging the VIX by a growing margin. For example, they notice that over the past few weeks the VIX has moved by a certain magnitude, but their investment in volatility ETP like VIIX is lagging by several percentage points. Some might think it a short-term fluke, but the longer they hold, the larger the difference grows between the actual changes in the VIX and the changes in their holdings.
To graphically see this relationship of lagging performance play out, here is a chart of the past 5-6 years of performance in the VIX.
And here is a chart of the 5-year return of VIIX.
There’s a glaring difference between these two charts. The first chart shows that the VIX is actually up about 100% over the past 5 years. But the second chart shows that an investment in VIIX is down about 88% over the last 5 years. Why is this? What is driving such a huge disparity in performance between something which is supposedly holding the VIX and the index itself? The answer: roll yield.
Let’s start from the beginning. Let’s say you are the investor in our prior example who wants to buy the VIX and speculate on the changing levels of volatility in the market. The VIX itself represents an implied volatility calculation on a basket of S&P 500 options which mature about 30 days into the future. For you to earn a return similar to the changes in the VIX, you would need to go out and purchase the options included in this basket which would expose you to a lot of transaction and turnover costs rendering this to generally be a losing proposition for most individual investors.
However, there are futures contracts which settle off of what the VIX is reported at on a certain day provided by the CBOE. The only catch is this: VIX futures are generally in contango which means that they increase in value the further out along the curve you trade.
The underlying reason for contango is actually fairly intuitive. On average, things are normal. This simplistic statement contains a lot of truth when it comes to trading volatility and contains a world of meaning for the pricing of futures. Since market volatility is relatively subdued during normal times, this means that odds that future levels of volatility will be higher increases as time goes on. In other words, if you had a futures contract that traded off of future volatility, it makes sense that the further out you look into the future, the greater the chances that something abnormal will happen and therefore the greater the chance that volatility will increase in the future (and therefore the curve will be in contango).
This may seem like a pedantic wording exercise, but it’s very important to grasp in that it is directly tied into the price of VIX futures – which VIIX tracks. Since most times are normal and the risks of abnormality occurring at some point in the future increase the longer your time horizon, it makes sense that VIX futures increase in value out along the futures curve.
In other words, on average, the VIX futures contract which settles off of what the VIX will be next month should be priced cheaper than the VIX futures contract in the month after (and so on along the curve). This is called contango – and it represents how VIX futures have traded in 87% of all trading days for the past decade (in other words, most of the time, things are normal and therefore VIX futures are in contango).
Okay, so what’s the point? Why does it matter that VIX futures are in contango? Glad you asked. To understand the answer to this question, let’s circle back to the normal/abnormal discussion in the previous paragraphs. Contango is the natural state of VIX futures – risks of abnormality and therefore higher volatility increase through time. However, as time progresses, assuming that most of the time markets remain normal, the abnormality which futures contracts were pricing in will gradually be priced out of contracts.
What this tangibly means is that since VIX futures are generally in contango to price in the higher probability of volatility increasing in the future, as time goes on, this uncertainty slowly becomes more certain and futures gradually approach the spot level of the VIX. This is called “convergence” in finance and the concept is captured perfectly in the following chart from Wikipedia.
What this chart essentially shows is that through time, futures prices move towards the spot price as the “uncertainty” is priced out of the market. This has huge ramifications for VIX-tracking notes like VIIX because the VIX generally doesn’t go anywhere – as can be seen in a long-term chart of the index.
As you can see in the chart above, the VIX tends to generally stick around 15-20 and excursions beyond this range are reverted within a few weeks or months. What this means is that if you could somehow hold exposure in the VIX over long periods of time, your returns would generally be flat over long periods of time.
For holders of VIIX, we have a problem because we’re not actually holding the VIX, we’re holding VIX futures. And here’s the tie-in to our earlier discussion: since VIX futures are almost always in contango and this level of contango is declining in value through time and since the VIX itself doesn’t really go anywhere over long periods of time, most of the long-run return of VIIX will be directly tied to the contango being priced out of the curve.
To graphically see this, here is the average level of the VIX as well as the front and second-month VIX futures contract by each trading day of the month over the last decade.
This chart is fairly powerful for understanding the difference between the returns of the VIX and the returns of VIIX. On average, the VIX basically goes nowhere (as seen by the VIX Spot line just going sideways during the month). However, the front-month VIX futures contract typically starts a month about 5-10% above the spot level of the VIX. And this 5-10% premium declines as a month progresses and futures converge to the spot level of the VIX. VIIX starts the month holding exposure in the “Month 1” line and throughout the month shifts exposure into the “Month 2” line – each of which is declining in value as the month progresses.
This is why etf.com says, “volatility ETPs deliver poor long-term exposure to the VIX index.” Roll yield is negatively impacting VIIX in 87% of all trading days, which means that VIIX is generally declining due to futures convergence. For this reason, VIIX just keeps dropping – and likely will keep dropping.
For this key reason, I cannot recommend that investors hold VIIX. Roll yield has impacted its underlying index to such a degree that it has dropped at an annualized rate of 47% per year for the past decade. In other words, over the past 10 years, VIIX has eroded shareholder value at a pace of about half per year – and this is almost entirely due to futures prices converging towards spot in a contango market.
So in conclusion, if you were lucky enough to capture the upside in VIIX this year, I would encourage you to take profits. If you are considering purchasing VIIX, I would ask you to carefully consider the above analysis as well as the long-run returns of this instrument. It has a proven track record of destroying wealth. In the words of etf.com, “volatility ETPs erased vast sums of investor capital over the past 12 months”. In this piece, I have given a deep dive into exactly why volatility ETPs erase vast sums of capital. Please protect your money and avoid a long-term exposure to VIIX.
Conclusion
VIIX has delivered a strong return to investors this year as the VIX has popped – but the long-run returns are against volatility bulls. Roll yield has historically decimated holdings of ETPs following the VIX and losses from roll yield are the natural state for VIX futures. It is time to take profits in VIIX and avoid purchasing at this point.
This article was written by
Analyst’s 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (3)
That's actually not too bad. Of course you're not going to make money directly on VIIX, it's more like insurance for the rest of your portfolio. You could compare it to buying protective puts, which will also lose money over the long term, but can still be a useful hedge.
