A popular ETF-like investment is designed to protect against portfolio losses in the event of a stock market crash. But most investors have no idea that holding this Exchange Traded Note (ETN) is likely to cost them more money than any market crash ever could.
The “fear” index
A few days ago, I discussed how the VIX – sometimes called the “fear index” – is near historical lows. The VIX measures demand for options in S&P 500 stocks used by big investors to insure their stock portfolios against loss. A high VIX reading indicates investors expect high volatility in coming weeks, and their demand for insurance is driving option prices higher.
However, recent low VIX readings (around 11) suggest that there’s less demand than usual for options protecting against market declines. Often in the past, this lack of worry by investors has been “the calm before the storm.” The last time the VIX was below 11 was in 2007, just months before the global economic crisis broke out.
But while markets rally and complacency grows, risks to the global economy are building. Stock valuations are high, especially after the “Trump rally” has pushed the S&P 500 up nearly 10 percent since the election. Also, interest rates are heading higher. After seven years of printing money, the U.S. Fed has signaled the “era of easy money” is coming to an end. And U.S. President Donald Trump is intent on extensive changes to U.S. policy, but his confrontational style has ignited lots of controversy and created high levels of policy uncertainty.
Yet, despite these risks, the fear index is stalled near 11. In past crises, the VIX spiked to levels of 40 and even 80. (If you could buy the VIX like a stock, the potential upside would be enormous, because if stocks fall, VIX profits could offset losses.)
Unfortunately, unlike the S&P 500 or other indices, there’s no way to invest directly in the VIX index. Of course, that hasn’t stopped financial engineers from creating derivative products that try (mostly unsuccessfully) to track the VIX.
VIX futures and options on futures have been around for years. However, futures in general are risky – and futures on volatility even more so. These instruments are only for experienced traders who can afford to lose their entire investment very quickly.
The VXX: The worst performing “fear tracker”… ever
In January 2009, at the height of the financial crisis, a retail product was created to track the VIX. VXX – the iPath S&P 500 VIX Short Term Futures ETN – was launched. What followed was possibly the worst performance of an ETF-like product in history. You can see how bad VXX performed in the graph below since its inception in 2009.
If you had bought VXX when it began trading in early 2009 and held it until today, you would have lost 99.94 percent of your money. To put this in terms of money, if you had invested $1,000 then, you’d have $6 left.
Despite that the ETN has done four separate 1-for-4 reverse splits, which should have quadrupled the stock price, it still trades for pennies. (That’s why the graph above shows the share price as being tens of thousands of dollars – the graph reflects the reverse splitting of the stock after it fell.)
How is such nightmarish performance possible? And why does VXX continue to trade tens of millions of shares per day, and still have US$1.2 billion in assets?
First of all, VXX is not an ETF (an exchange-traded fund) – it’s an ETN (an exchange-traded note). There are big differences, most importantly: While an ETF is a fund that usually holds the actual securities of the index it tracks, an ETN is an instrument that seeks to track the performance of an index. What that means is that it doesn’t hold actual shares of, well, anything.
For instance, if you buy a share of EEM (iShares MSCI Emerging Markets ETF), you own a bit of each stock in the MSCI Emerging Markets Index. But if you buy a share of the VXX ETN, you own interest in a promissory note from iShares. With your money, the institution will attempt to track the VIX index. (We wrote about the dangers of ETNs previously.)
Also, VXX seeks to track the VIX over short periods – that is, days. It does this by always holding VIX futures. The fund does not attempt to track VIX over the long term, though many investors don’t realize this. We’ve discussed hidden ETF risks before.
The futures contracts the ETN holds increase in value if the VIX goes up. But futures contracts have expiration dates, so VXX must periodically sell expiring futures and buy new ones.
VXX usually buys futures with two months or so until expiration. But with each passing day, the time value in the contract prices decrease. As expiration approaches, the fund “rolls” the expiring futures contract (which have lost most of their time value) into new, further-out contracts with lots of time premium.
VXX is almost always buying futures, which are decaying in value, buying high and selling low. This guarantees that the price of VXX falls over time.
The obvious question is: Why would anyone buy VXX?
The reason is that if a speculator times a market drop perfectly, VXX – and other VIX-related ETNs – can generate huge returns over a very short time. For example, after the Brexit vote on June 23, 2016, the S&P 500 plunged by 3.6 percent, and the VXX jumped to 26 from 17 – a gain of 52 percent.
But unless you know exactly when stock markets will crash (please contact me if you can, in fact, predict the future), VXX does nothing but eat your money. My advice: If you’re in search of this kind of gambling action, go to the casino where you can at least have some fun while you lose money. And forget about buying VXX or other VIX-related ETNs.
What about the other way?
But wait, I hear you saying: “If over time VXX decays nearly every day on a death march to zero, what if I short it, and profit from the constant price erosion?” (If you “short” a stock, you sell it first, then hope to buy it at lower prices, profiting the difference.) As it happens, you wouldn’t be the first person to have thought of this.
While sound in theory, there is a problem with this strategy. On most days, the price of VXX will drip lower. Week after week you’ll accumulate small profits. But then, out of the blue, an event like Brexit comes along, stocks tank, and investors desperately buy options for insurance – and the VIX soars, along with VXX. You could lose 50 percent on your short VXX position literally overnight.
And who knows what sort of market crashes will happen in the future? You might wake up some morning and you’ve lost 90 percent of your money shorting VXX.
The XIV: A “fear tracker” for experienced investors only
There’s even an ETN that investor’s use as a way to profit from VXX decay. The ETN is XIV (VelocityShares Daily Inverse VIX Short-Term ETN). XIV in essence “shorts” the VIX. Here’s how this instrument is described by the note’s issuer:
“XIV offers extremely liquid inverse exposure to short-term VIX futures in an ETN. The fund accurately delivers -1x exposure – one day at a time—to first- and second-month VIX futures. This fund does not provide inverse exposure to the VIX index itself, which is truly uninvestable.”
So, XIV is attempting to track the inverse return of the VIX on a daily basis. However, over long time periods, just as VXX continually loses from the decay of VIX futures’ time value, XIV tends to profit from the decay. Since the VXX goes DOWN most weeks, the XIV goes UP most weeks. In fact, since its inception in December of 2010, XIV is up over 500 percent.
But before you rush to buy XIV, consider this: From August 9 to August 30 of 2015 – during the China market meltdown – XIV fell from 48 to 23. That’s a 52 percent drop in 3 weeks. And that’s just one of XIV’s crashes. Keep in mind that a 50 percent decline in an investment requires a 100 percent gain to recoup the loss. An 80 percent loss requires a 500 percent gain to get up to breakeven.
The fact is, XIV is too volatile to make it a realistic buy-and-hold investment. Indeed, any investor putting money into VIX-related ETNs is playing with dynamite.
How to profit from “fear” without buying dangerous ETNs
Rather than gambling with VIX products, a more sensible reaction to the low VIX is to make your portfolio more defensive. For example, you could raise some cash, consider taking some profits on high-flyers, and hold off on new purchases until markets show better values.
Also, buy some gold. Buying gold bullion, physical gold ETFs, or gold stock ETFs, is the preferred strategy for insuring one’s portfolio against rising market risks. It’s also a smarter, less risky way to speculate on possible market turmoil. When the VIX spikes higher, you can bet that the price of gold will also rise.
For instance, from June of 2007, when the financial crisis first broke, to the March 2009 bottom, global stocks dropped about 45 percent. But the price of gold rose about 40 percent over the same period.
And unlike wildly volatile VIX ETNs, gold is an asset that you can hold long term. Precious metals are not correlated with equities, and add stability to you portfolio, while providing protection against future inflation.
The historically low VIX index combined with lots of uncertainty could be foreshadowing market volatility. But don’t buy VIX-based ETNs – they’re complex, unreliable instruments with too much risk. During periods of fear and uncertainty, investors have traditionally turned to gold as a storehouse of wealth.
I’ve written about gold before, and in the upcoming issue of the Asia Alpha Advisory I’ll tell subscribers about my favourite ways to invest in gold. (Go here if you’re not a subscriber but want to be… you’ll hear me talk about one of my favourite markets as well.)