As you can see in the following chart, the iPath S&P 500 Dynamic VIX ETN (XVZ) has somewhat surprisingly held its ground over the past few months as the spot VIX level has reverted towards the mean.
Despite this resilient performance, I believe that in the long run, XVZ is headed lower. Specifically, I believe that the only appropriate use of this trading instrument at this point is as a portfolio hedge and that the odds favor continued downside in the note.
Understanding the ETN
If you’ve ever dug into the finer points of XVZ, then you’ve likely encountered a pretty simple but important truth: this ETN is remarkably complex and highly nuanced. Put simply, not only is the volatility ETP space fairly complicated but XVZ takes it to the next level by following a methodology which dynamically changes between two other methodologies depending on market factors.
Within the volatility ETP space, the two most popular methodologies are both provided by S&P Global:
By far, the most popular methodology of the two is the short-term variant – an index which popular ETPs like VXX and UVXY track on an unleveraged or leveraged basis. However, these two indices represent basically all large and liquid volatility methodologies available to retail investors.
If you’re unfamiliar with these indices, I’d suggest clicking through the above lengths. Specifically, I’d zero in on the long-run returns of these methodologies. For example, the short-term index has declined at an annualized rate of about 50% per year for the last decade while the mid-term index has fallen at a rate of about 20% per year during this same time frame.
It’s hard to fully wrap the mind around those kinds of returns on long run performance, but put simply, if you have invested in either of these indices for more than 1-2 years, you likely will never see breakeven on your investment. In fact, the longer you hold exposure to either of these indices, the greater the chances are that you’ll lose most of your money.
Why is this the case? What is it about these indices which continue to be very poor deliverers of long-term value? That answer is of course roll yield: put simply, VIX futures contracts are almost always priced higher than the spot level of the VIX which means that through time, futures contracts are declining in value in relation to the spot.
This chart shows the various futures contracts which go into these two popular indices. The short-term index is holding the first and second month contracts while the mid-term index is holding exposure across the fourth through seventh.
The data graphed is the average differential between the spot level of the VIX and these four futures contracts, grouped by the number of days until the expiry of the front contract (using the last 10 years of data). What this data shows is a few surprisingly clear relationships:
- The further a VIX futures contract tends to be from expiry, the greater the premium it tends to hold versus the spot level of the VIX.
- All VIX futures contracts tend to narrow towards the front of the curve during an average month, but the closer a contract is to expiry, the greater the degree of narrowing experienced.
Put simply, there really is no way to escape roll yield. Since VIX futures are largely priced above the spot level of the VIX and since these futures are converging towards the spot level, losses abound for long traders in volatility ETPs tracking these two methodologies.
But here is where XVZ’s methodology enters the picture. The S&P 500 Dynamic VIX Futures Index is essentially playing a game of “hot potato” between the short-term and mid-term index. How it works is that it basically calculates which index is losing the least amount of value through roll yield at any specific point in time and it shifts exposure into that index.
As you can see in the above chart, this dynamic index has dramatically outperformed the two more popular indices with a 10-year annualized loss of about 1.5% per year. In fact, if you had bought this index at any point since 2013, you would have turned a profit at some point this year due to the historic rally in the VIX.
If you’ve followed VIX indices for any length of time, then this last statement probably seems too good to be true. VIX methodologies like the short-term and mid-term index have a notorious history for eroding value and dramatically so. The fact that an index could have been purchased as far as 7 years ago and still seen some profit seems very unusual indeed.
In my opinion, we need to look more closely at the data prior to giving any sort of recommendation on XVZ. It is my belief that this year was a very large outlier in the history of VIX data and that the most recent data should be properly framed up before being relied upon for an investment.
What I mean by this is that while this year saw very strong performance in the VIX, it is important to remember that this was one of the largest moves in history. If you are using a large and substantial rally as the basis for understanding your potential investment returns then you are likely going to be disappointed. For example, prior to the rally seen this year, XVZ was declining at a rate of a little over 7% per year – much smaller than the 50% and 20% declines seen in the other indices, but this is still a material amount.
And also, note that XVZ did not give much protection at all during the “melt up” seen in the VIX during the early part of 2018. Indeed, during the first few weeks of 2018 the VIX rallied by nearly 400% while XVZ’s methodology increased by only a few percentage points.
My ultimate point is this: XVZ may have delivered very strong returns this year and it may still be holding on to those returns in the short run due to its current positioning; however, unless we expect further history-making rallies over the next few quarters, then investors are likely going to lose money on XVZ through time.
This doesn’t necessarily invalidate an investment in XVZ, but I believe this ETN can be expected to continue to lose and that investors should only hold this product as a tail-risk hedge – and a hedge which likely will only truly pay out in the event of a global financial panic similar to what has been seen this year.
In light of this necessity of panic for this ETN to truly pay out, I suggest investors forgo an investment in this product at this time.
XVZ offers a dynamic exposure between two different VIX futures indices. While XVZ has succeeded in removing a good portion of roll yield from a long VIX position, returns still skew negative through time. Given that only the strongest of financial panics tends to push XVZ higher, I believe that a long-run negative expectation on this ETN is in order.
Disclosure: I am/we are short VXX. 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.