As you can see in the following chart, the iPath S&P 500 Dynamic VIX ETN (XVZ) has held its ground and actually increased somewhat over the past few weeks on the back of strength in the VIX futures curve.
It is my belief that XVZ is likely headed lower in the future. I base this view both on analysis of the VIX itself as well as an analysis of the methodology of the ETN. However, I believe that in the short term, the odds actually do favor some additional upside in the note; however, in the long run, the prospects for an XVZ investment are not very good.
To start this piece off, let’s take a look at the recent VIX levels, trends, and movements to try and assess the future probabilistic movements of the index.
At present, the VIX is sitting at around 21 after having pulled back by about 75% from the highs seen earlier this year. The VIX is a highly mean reverting instrument which means that very simple studies like the following can be fairly powerful for calling short-term changes in the VIX (at certain points that is).
This study shows a very clear inverse relationship between the probability of the VIX rising and its outright level: given that the VIX is at around 21, there isn’t much directional probability at this time. What I mean by this is that over the past 27 years, the data shows that when the VIX is around this level, it falls about 54% of the time over the next month. Compared to the more dramatic readings in the above chart at the edges, this is essentially a non-starter: at present, there is little to no directional edge contained in studying the outright level of the VIX in isolation.
Seen from another perspective, the VIX has contracted for two months straight.
Historically speaking, there is a slight edge associated with the VIX trending in the same direction for two months: it tends to see the movement reversed.
What the above data shows is that there’s about a 55% chance that the VIX will be higher over the next month based on the fact that it’s contracted for two months straight. Again, these odds are not terribly strong at this point which means that any edge in the current data using these studies is fairly slim.
We can, however, derive a degree of an edge from looking at what the VIX is ultimately derived from: the S&P 500 and its trading action.
At present, the market is in an unquestioned run-away trending environment. We have seen resistance level after resistance level be smashed by the overwhelming force of the trend and the market is currently trading at all-time highs.
If you look at the above chart, the data suggests that we are overbought according to the RSI. The Relative Strength Index is an indicator which measures the differentials between gains and losses over a certain time period and essentially can show when any given market is overbought or oversold. For example, on the above chart, I have drawn a line for every time over the past year when the RSI was at or around the current level. As you can see, three out of four of these occasions resulted in the market selling off over the next 2-4 weeks. And the one time which didn’t see the market collapse (December) still resulted in a slowing of the trend. Put simply, the market is overbought and history shows that when it’s overbought, it tends to weaken over the next 2-4 weeks the majority of the time.
For VIX traders, the key thing to keep in mind here is this: the VIX is a value which is derived from options on the S&P 500 and it is inversely correlated to changes in the market.
What this data shows is that if we were to see a market correction in the territory of 5-10% (which would be in line with the most recent correction), then we could see the VIX rally by about 25-35%. Given that we’re currently overbought and given the market’s tendency to reverse these levels, I believe the odds favor upside in the VIX at this point.
As traders in VIX ETPs, we need to make one thing absolutely clear: there is a very big difference between having a view on where the VIX is likely headed and where any specific VIX ETP is likely headed. The reason for this is actually quite simple: VIX ETPs are based off of VIX futures rather than the VIX itself and there is a difference in both the value of VIX futures and the performance of VIX futures through time.
XVZ is a very interesting ETN in that it is attempting to solve the problem of roll yield in VIX futures by dynamically shifting exposure across two different methodologies. These methodologies are:
- The S&P 500 VIX Short-Term Futures Index – an index which holds and rolls exposure in the front two months of VIX futures contracts. This index has declined at an annualized rate of 49% for the past decade.
- The S&P 500 VIX Mid-Term Futures Index – this index holds exposure in the fourth through seventh month VIX futures contracts and it has declined at an annualized rate of 20% over the past decade.
At the risk of being too simplistic, XVZ is essentially playing a game of “hot-potato” with two indices which have a demonstrated track record of reducing wealth from followers. Interestingly enough, this index has actually managed to reduce roll-yield losses to the territory of about 2% per year for the past decade.
While this 2% annualized loss may seem insignificant, I’d encourage you to dig into the data. What you’ll find is that if you remove this year’s epic rally in the VIX from the data set, the annualized loss is generally somewhere in the territory of 7-10% per year. In other words, remove one of the biggest rallies in the history of the VIX from the data and the numbers aren’t that favorable.
The basic problem here is this: VIX futures are generally priced higher than the spot level of the VIX. And through time, this differential narrows with the front contract trading to parity with the spot level of the VIX around the time of expiry. If you understand this general concept, then you understand the problem of roll yield.
While convergence happens across the entire curve, it is most heavily felt in the front – which is why the short-term index declines at twice the rate of the mid-term index. However, you can’t escape from roll yield in a contango market which is why all of these indices lose value through time.
XVZ is basically hopping between indices in an attempt to minimize roll yield – and it does a decent job at it. However, unless you see an incredibly strong rally in the VIX, the data clearly shows that year after year of losses is what one can expect from this product.
My overall view on XVZ is this: the odds favor a rally in the VIX over the next few weeks due to the reasons we discussed in the prior section. However, in the long-run, XVZ is likely going to fall due to futures convergence in a contango environment. For this reason, I’d suggest that short-term traders may want to consider maintaining exposure, but for longer-term traders, I believe the party is largely over and that the ETN is generally headed lower from here.
The VIX is likely to rally in the short term due to an overbought market. Roll yield takes a toll from all major VIX indices. XVZ is likely headed higher in the short term, but in the long term, futures convergence cannot be avoided.
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.