VIIX: The Trend Remains Downwards
Summary
- VIIX has continued its drop as the S&P 500 recovers following the sell-off earlier this year.
- Roll yield remains a predominant factor in explaining the returns of VIIX and investors need to pay attention to this figure.
- Both trend and level analysis of the VIX suggest that the index is headed lower in the immediate future.
As you can see in the following chart, the past few weeks have not been favorable for long traders in the VelocityShares VIX Short-Term ETN (VIIX) with shares continuing to decline after the surge early this year.
While investors may be tempted to view the recent selloff as a buying opportunity, it is my opinion that any gains are likely to be only short term and that in the coming months we will continue to see VIIX head lower.
Understanding VIIX
Let's start this article off with a look under the hood at the mechanics of this ETN. Put simply, VIIX follows the S&P 500 Short-Term VIX Futures Index which is a methodology provided by S&P Global. The following chart shows the last 10 years of return for this methodology. VIIX is an ETN which tracks this strategy in lockstep so this effectively is equivalent to the return shareholders would have made had investors held the note during this time period (granted, this is impossible due to the listing date of the note).
As you can see, this index has shredded value for long traders to the annualized tune of about half per year. If you parked $100 in this index 10 years ago, you'd only have some change left now. If you are considering purchasing VIIX, think carefully about this: over the past year, there have only been a few one-year periods in which you would have earned a profit. For the most part, quarter after quarter of consistent losses are the norm for holders of this note.
The reason here is pretty simple: roll yield. I've covered this in depth before so I'll make it brief in this piece. But the basic problem is that VIX futures are generally priced above the spot level of the VIX (and tend to increase in value as you look further out along the curve).
The recent months have been turbulent which has resulted in a very volatile VIX futures forward curve, but the above chart shows the contango seen in the current futures curve (using yesterday's settlements). Of note, the spot level of the VIX is currently sitting at 26 which represents a difference of about 7% between the VIX itself and the front VIX futures contract.
The key concept of roll yield is this: over time, this difference between futures contracts and the spot level of the VIX will converge to be around zero at the time of expiry. That's it. If you understand this, you understand why notes like VIIX continue to decline through time and why they tend to make bad investments. Since VIIX is tracking the front months of VIX futures, it bears the brunt of this convergence.
On average, VIX futures are priced above the spot level of the VIX (87% of all days for the past decade) and as time progresses, this distance shrinks as futures "roll down" or fall to the spot price. This results in quarter after quarter of losses and is the driving force behind the short-term index dropping by about half per year over the last decade.
What this process ultimately results in is a decoupling between the returns in VIIX and the returns of the VIX itself.
For example, in the above chart I have calculated the correlation between changes in the VIX and changes in the short-term index (again, the one which VIIX tracks) over a certain holding period. As you can see, the longer you hold VIIX, the less your investment will tend to correlate with the VIX itself. This practically means that if you're holding VIIX for anything longer than a month or so, your return essentially becomes a function of something else (roll yield) and the actual movements of the VIX eventually become irrelative to your total return.
The progressive nature of roll yield losses can be seen when we take this same data and instead measure the difference in performance between the VIX and the short-term futures index.
As can be seen, the longer you hold VIIX, the greater you can expect to underperform the VIX. In fact, after holding VIIX for about a year or so, you will need the VIX to double before you will even near breakeven on your investment.
In case you can't tell, I'm not a fan of a long-term hold in VIIX. Roll yield erodes value of shares and my experience discussing with traders and investors in notes like VIIX is that a good percentage (perhaps half) of those involved are unaware of these factors. For this reason, I make it a strong point to highlight this key feature whenever possible.
VIX Markets
Now that we've established a general expectation for the short-term VIX futures index (it drops at a rate of about half per year), let's turn our eyes to the current VIX market to generate a thesis for where the VIX is likely headed. First off, let's look at the outright level of the VIX to gauge the probabilities of directional movements from here.
The VIX is currently sitting a little above 26 at the time of writing. The last 27 years of data suggest that there's about a 75% chance that the VIX will be lower over the next month. In other words, simply based on where the VIX currently is, the odds strongly favor downside from here.
As a rough gauge as per the magnitude of potential declines, I have gone back and examined the average percent change of the VIX over the next month following levels similar to where we are currently trading. The numbers suggest that if we see a movement in line with average, the VIX will likely drop by around 13% over the next month.
While the odds do favor more downside from here, a few other mean-reversion methods are suggesting that in the short term, there is a slight chance that we may be temporarily in store for a rally in the coming weeks.
The above chart takes the last 27 years of monthly data with the VIX and asks what the probability is that the next month will be up given a specific trend of consecutive monthly changes. For example, when the VIX has risen by 4 months straight, there's historically only been a 14% chance that the VIX will be higher over the next month.
What this study currently shows is that given that we've seen two straight months of declines in the VIX, there is a slight chance that we'll see upside this month with the odds coming in at around 55%.
So what do we do when we have two separate studies which say slightly contradictory things? We have a few different approaches, but I'm more inclined to rely on studies with more data points and clearer trends. For example, in our study showing the odds of the VIX rallying given a specific level, this relies on a few thousand data points whereas this second study only has a few hundred months making up the series.
Also, we can dig a little deeper into the numbers to figure out what's going on here. Specifically, when we factor in the outright level of the VIX as part of this trend analysis, the numbers become fairly bearish on the VIX. For example, of all of the times in which we've seen the VIX fall two months in a row and the latest level of the VIX is above 25 have seen the VIX fall a whopping 67% of the time with an average decline of 15%. In other words, based on the current level of the VIX, the odds suggest that the trend is going to continue and that we are going to continue seeing downside over the next month.
For all of these reasons, I believe that VIIX is a bad play at this time. Not only does roll yield eat away at returns over lengthy periods of time, but also level analysis and contextualized trend analysis each suggest that the odds favor further downside.
Conclusion
VIIX has continued its drop as the S&P 500 recovers following the sell-off earlier this year. Roll yield remains a predominant factor in explaining the returns of VIIX and investors need to pay attention to this figure. Both trend and level analysis of the VIX suggest that the index is headed lower in the immediate future.
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.
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