As you can see in the following chart, the iPath S&P 500 Dynamic VIX ETN (XVZ) has seen a fairly substantial rally this year on the back of one of the largest movements in the VIX ever seen.
In this piece, we will do a deep dive into the underlying methodology of XVZ to arrive a long-term trading recommendation. It is my view that for the most part, the movement in the VIX is likely over at this point which means that the long-run expectation for the ETN is firmly negative. In other words, I am bearish XVZ.
Understanding the ETN
If you’ve found yourself reading an article about this peculiar ETN, then you’re likely at least somewhat familiar with the various volatility ETPs available as well as the key constraints and limitations impacting shareholders across the space. In short, the major problem with all current and popular volatility ETPs is that roll yield takes a massive toll on returns of volatility products. We’ll discuss this in depth in the following paragraphs, but in short, the problem of roll yield is that volatility ETPs are tracking VIX futures and since VIX futures are generally in contango (priced higher than the spot level of the VIX) and since futures converge towards the spot price through time, long-term investors in volatility products almost consistently lose money when observed over lengthy time periods. XVZ is an ETN built upon an index which attempts to minimize this impact upon returns. Let’s dive in and explore these various factors to see how well XVZ is able to deliver on its mandate.
In the volatility space, the vast majority of invested funds are following the S&P 500 Short-Term VIX Futures Index provided by S&P Global. Here is the long-run return of this index.
The above chart shows that the short-term VIX index declines at an annualized rate of around 48% for the past decade. It’s hard to full wrap the mind around how extreme these declines are, but to get some perspective here: if you had invested in this index 10 years ago, you would only have a few pennies left for every $100 you placed in the index. Said another way, you would need to make a return of several hundred thousand percentage points to even be breakeven on your investment.
I’ve pulled the data represented in the above chart to do a few calculations around this index. One of the things which becomes abundantly clear is that the longer you hold the above index, the greater the odds that you will lose money.
What this chart shows is a comparison of the return between the VIX itself and the index which purportedly is tracking general movements in it. As you can see, there is a clear, almost linear relation between holding period and underperformance versus the VIX: the longer you hold this index, the greater you will underperform against the VIX.
This is the major limitation of the short-term futures index: it strongly drops in value through time. The basic math generally suggests this: if you hold exposure in this short-term index for longer than a year, you likely will never recuperate your initial investment.
S&P Global seems to have been generally aware of the limitations of this index, so they also created the mid-term futures index to push exposure further out along the futures curve. The general problem of roll yield is that futures converge to the spot price and since you’re holding futures rather than the spot commodity, your return will be dependent on the magnitude and timing of this convergence. Since the convergence tends to happen mostly at the front of the futures curve (since the convergence is in effect the futures contract pricing to become the spot commodity), investors can mitigate roll yield by shifting exposure to later months.
This is the premise of the mid-term futures index provided by S&P Global – it moves exposure into the fourth through seventh futures contracts rather than just the first two (which is the short-term index’s exposure). Here is the long-run return of this index.
This chart shows that the mid-term futures index declines at an annualized rate of about 20% for the past decade. This is a reduction in roll yield by about half and at least gives VIX investors a fighting chance if exposure is held over longer periods of time. However, the math of compounding still works: if you held exposure to this index for longer than 2 years or so, you likely will never see a positive return on your investment.
We’ve done a bit of a lengthy exploration of two VIX indices for a key reason: XVZ is following the dynamic VIX futures index. How this index basically works is that it utilizes these two prior indices and dynamically jumps between the two of them in an attempt to minimize roll yield. Here’s the long-run return of this index.
There’s some good news and some bad news contained in the above chart. The good news is that this index did a successful job of minimizing roll yield to the extent that this year’s record rally in the VIX resulted in returns which erased several years of roll yield losses. The bad news is that roll yield losses still seem to be normal with basically most 52-week periods in the above chart prior to 2020 containing non-stop losses.
What this analysis basically shows is this: roll yield is an inescapable reality of investing in VIX futures. For example, here is a chart that I have created which takes the average differential between VIX futures contracts and the spot level of the VIX by the trading day in a month, using the last 10 years of data.
As you can see, there are a few very clear relationships in the data. One of these relationships is that the majority of the time, futures are priced above the spot level of the VIX. And this feeds into the second relationship which is that through time, this difference convergences, but this convergence is most heavily felt on the front contract (which is expiring at the end of this chart – at which point the “M2” line becomes “M1” and so on).
This chart shows that roll yield is inescapable – no matter where you hold exposure in the above data, you will see losses from roll yield over length time periods. This means that ultimately, XVZ is essentially playing a game of hot potato with two indices which are dropping through time: it may be able to minimize getting burned by passing the potato, but over time the burns add up to serious damage.
As you can see in the chart of the long-run performance of XVZ, the returns are generally negative and it requires a global financial crisis for gains to be seen in this index. From this perspective, an investment in XVZ only makes sense in light of a long-term hold and as a hedge against an existing portfolio. Roll yield is almost certainly going to continue eroding holdings and this erosion is historically only reversed by dramatic increases in volatility. Given that these “black swan” type events only happen every 10 years or so (2001, 2008, 2020), I am bearish XVZ as a stand-alone investment outside of portfolio considerations. Unless you are doing a hedging strategy using XVZ, I suggest not holding exposure to avoid losses from roll yield.
XVZ is an ETN which dynamically shifts exposure between two different volatility ETNs. Despite the fact that very strong gains have been seen this year in XVZ, prior to 2020 near-constant losses has been the expectation for this product. Unless XVZ is used as a portfolio hedge, the inescapable reality of VIX futures roll yield necessitates a long-term bearish bias on this instrument.
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.