ΧΙV has been one of the most controversial securities out there and for a good reason. Although it is not officially classified as a leveraged ETF, its structure and performance have a lot in common with this category of products. Specifically XIV tries to replicate the inverse of the daily return of the VIX through the sale of VIX futures (the first two months of the term structure), while maintaining a constant maturity of 30 days. XIV gains value when the VIX futures are in contango and the value of the future contract moves towards the VIX spot price (the latter being lower than the former, as is the case in contango).
XIV was greatly benefited, since its inception in 2010, from the bull market that started in 2009. Calm and complacency in the markets was the norm and this led to a great decline in volatility for an extended period of time. In fact, it was the best performing unleveraged ETF from 2011 to 2014 producing cumulative return in excess of 700%. However, the collapse of August led to an extreme spike in volatility unseen before 2008. XIV lost more than half of its value in a space of 20 days and has barely recovered since then. So, the question here is whether these levels are attractive, and if yes, whether we should view XIV as a long term play that can produce steady returns as it did before the China-driven crash of last summer.
The main critics of XIV point to the fact that the fund has a lower Sharpe Ratio compared to leveraged products tracking the indices or sectors. According to this view, an ETF with identical beta will outperform XIV without bearing the same level of risk. XIV has a beta of approximately 4. The problem with this rationale is that the correlation between the returns of S&P and XIV is spurious at best. 4% beta means that for every 1% of the move of the S&P 500, the XIV will move towards the same direction by 4%. However, this is far from being the case… Here is a graph with the performance of S&P and VIX since the fund's inception
XIV gained 170% in 2012 while the S&P gained 16%. In 2013, the greatest year of the bull market when the S&P posted a 32% gain, XIV increased "only" by 82%. It is clear that a steep rise in stocks ,though undoubtedly has a great impact on the XIV price increase, affects the value of ETF in asymmetrical ways. The implication here is that a steep rise in stock prices is not prerequisite for a new huge XIV run. What is really necessary though is a new long period of calm and complacency like the one we experienced until last August. Between 2012 and 2015 VIX remained below 20 for almost the entire period. Moreover, the term structure of VIX futures experienced no backwardation from 2012 to 2014 which is a very crucial factor for XIV.
Complacency does not necessarily mean that the S&P will rally as strongly as it did the last 5 years. If market avoids turbulence and volatility stabilizes around the all time median (close to 17), then a new period of glory for XIV is under way. ECB is finally ready "to do whatever it takes to save the euro", while the Fed is reluctant to commit to a round of successive rate increases. Oil and commodity prices seem to be finding a bottom and emerging markets are ready for a comeback. If the above assumptions hold, there is no better place to be than XIV
Disclosure: I am/we are long XIV.