Between the beginning of the second half of 2011 and the middle of December, few exchange-traded products endured a tougher stretch than the VelocityShares Daily Inverse VIX Short Term ETN (XIV); the exchange-traded note plummeted last summer as the “fear index” spiked and VIX futures markets entered a rare stage of backwardation. Those two elements–increases in the spot VIX coupled with market expectations of an upcoming decline–spelled trouble for a product designed to deliver daily inverse exposure to a benchmark comprised of short-term VIX futures contracts [see Low Volatility ETFs Attract Big Inflows].
But right around Thanksgiving, XIV has experienced an abrupt change of fate and climbed sharply higher; through Wednesday’s close, this ETN had gained close to 40% since Turkey day. The reason behind that sudden surge is two-fold. The big decline in the VIX, which measures expectations of short term equity market volatility, certainly hasn’t hurt; the so called “fear index” has declined by about 35% over that period. XIV has also been aided by a return to the normal environment for VIX futures; this market is in a state of steep contango at present, with both short-term and mid-term futures contracts trading at a material premium to the spot VIX.
|12/1/2010 – 5/31/2011||+96.9%|
|6/1/2011 – 11/25/2011||-73.9%|
|11/28/2011 – 1/4/2012||+42.4%|
For XIV, that’s a combination that will generally translate into big gains. This ETN is constructed in a way that allows investors to potentially profit from contango–the very same phenomenon that is the cause of “return erosion” in many commodity exchange-traded products [see Futures Free Commodity ETFdb Portfolio]. When a futures market–whether for the VIX or a commodity–is sloping upward, strategies that involve “rolling” exposure as contracts expire are essentially flying into the wind; they are forced to buy high and sell low. Because XIV offers inverse exposure to such in index, it is positioned to thrive in that type of environment.
Time To Buy?
Since its inception in late 2010, XIV has perhaps been the ETP version of Dr. Jekyll and Mr. Hyde; this ETN has experienced periods of both huge price appreciation and big declines. Even after the recent spike in XIV, this ETN could be positioned for additional gains in the coming weeks [see also ETFs To Smooth Volatility: Looking At Some Long/Short Options]. Though the VIX has tumbled over the past month, it’s still more than 10% above its historical average–meaning that a further decline is certainly within the realm of possibility. But more importantly, the VIX futures market is in a state of steep contango–especially at the short end of the maturity spectrum. January futures were recently priced about 9% above the spot VIX, with the premium for March contracts approaching 20%.
|Month||Value||% Over Spot|
|As of January 4. Source: cboe.com|
XIV is a potentially intriguing investment opportunity for investors who expect markets to move sideways in the short- to intermediate-term [see XIV Returns]. Because it offers inverse exposure to an index comprised of short-term VIX futures, it essentially puts investors in the position of writing call options on the VIX. If the index shoots higher, that means obligations to the counterparties to those contracts. If the VIX holds steady–as it would likely do in a sideways market–XIV essentially pockets the “premiums” over spot prices built in to future prices. Put another way, this ETN allows investors to fill the role of the insurance company; if disasters hit the markets, they’ll be on the hook for the damages. If it’s smooth sailing ahead, they get to line their pockets with the policy premiums [see Six Noteworthy ETF Innovations].
There are, of course, some nuances that should be carefully considered and understood. XIV features a daily reset of exposure, which means that it is designed to track the inverse of the performance of the specified index over the course of a single day. Over longer periods of time, the impacts of compounding returns–which can work both for or against investors depending on the environment–can be meaningful. And it only takes a look at the chart for XIV over the last six months to appreciate the potential for swift and severe losses; if investor anxiety spikes again and the VIX surges, this ETN could feel the burn.
Disclosure: Long XIV.