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- On February 15th, 2018, trading of the exchange-traded note “XIV” was permanently halted ahead of its liquidation.
- XIV was a popular way to short VIX futures, earning a premium for insuring buyers against a spike in the VIX.
- Through 12/31/2017, XIV earned over 40% annualized per year since inception. It then lost over 90% of its value in two days.
- Investments do not exist in isolation. By rebalancing annually, and harvesting returns from XIV, we could have realized a positive return over XIV’s lifetime despite the catastrophic loss in value.
- We do not believe XIV was an inherently broken investment product, but rather should serve as a reminder to investors that earning return requires bearing risk. If a portfolio earns a consistently high return, it is likely an indication it is implicitly insuring against a catastrophic risk that has yet to manifest.
On February 15th, 2018, the VelocityShares Daily Inverse VIX Short-Term ETN (“XIV”) was delisted and struck its final indicative value. But it did not go gentle into that good night, posting a 12.3% return in its final week of trading.
Okay – maybe for any other instrument, 12.3% would constitute “raging against the dying of the light.” For XIV, it was less than a 1 standard deviation move. Quite common.
And the final gasp of life is likely little consolation to anyone who has been holding XIV for more than a few weeks. Anyone holding since early January will likely realize a +90% drawdown.
We’re no strangers to XIV. It was a product we wrote about numerous times. Ironically, our last piece about XIV was published on Monday, February 5th. By Tuesday morning, XIV was some -90.4% lower than its Monday open. Evidence, once again, that market timing is hard.
XIV’s demise is really is not too surprising for anyone who read the prospectus. We highlighted one line, in particular, in that fateful Monday commentary: “The long term expected value of your ETN is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment.” Caveat emptor.
Though, another clue as to what investors should have expected their long-term experience to be like might have been the banner image on VelocityShares’ XIV webpage. It is a blurry rollercoaster with a gentleman who appears to be suffering a serious case of whiplash or nausea.
Either would be appropriate, we suppose.
In The Black Swan, Nassim Taleb writes about another bird: the Thanksgiving turkey. For 1,000 days, a farmer takes care of the turkey, nurturing, feeding, and ensuring it stays in good health. To quote Taleb from a Charlie Rose interview, “every day confirms to the turkey and the turkey’s economics department and the turkey’s risk management department and the turkey’s analytical department that the butcher loves turkeys, and every day brings more confidence to the statement.”
With this prior, the Wednesday before Thanksgiving will be a rather nasty surprise in the turkey’s life.
The lesson of the turkey is one of induction: there is no way to know, for sure, that past experience will remain a guide to future experience. The 1001st day can be entirely, and unpredictably, different than the prior 1000. There is a reason every investment performance disclosure in the world contains some variation of, “past performance is not an indication of future results.”
The quintessential image accompanying the story is a graph exhibiting a line up and to the right followed by a sudden and immediate drop to zero.
Source: The Black Swan.
XIV’s 1-year price action looks much the same.
Source: CSI. Returns as split-adjusted total returns and assume the reinvestment of all distributions.
There is one key difference between XIV and Taleb’s turkey, however. The turkey cannot squirrel away its profits and survive past Thanksgiving.
It is often argued that the act of rebalancing, compared to a strict buy-and-hold strategy, helps portfolios profit from mean reversion in the underlying assets. In line with our philosophy that “risk cannot be destroyed, only transformed,” rebalancing foregoes the very best buy-and-hold returns (when winners keep winning and losers keep losing) to outperform when returns are less divergent.
Assume, for a moment, that we know one of our investments will ultimately go to zero. Reinvesting our winnings does not make much sense, as we know we will ultimately lose them. Therefore, at the end of each year, we take our winnings and hold them in cash so that we only ever bet our original outlay.
What is the minimum rate of return that would be necessary such that, if we lost our investment after T years, our wealth would be at least equal to our initial investment?
If we lose our money at the end of the first year, then it does not matter what the return was: we’re broke. If we lose our money at the end of the second year, we would have needed a 100% return in the first year to still have our original wealth. If we lose our money at the end of the third year, we would need to have had at least an average 50% return in the first and second years to still have our original wealth. The basic formula is that we would need our average return to be 1/(T-1).
So even if we end up losing all of our invested capital, if our rate of return is high enough, we can still create a profit by siphoning off our winnings over time. The longer the investment survives, the lower we require the return to be.
While rebalancing does not technically siphon off all the capital winnings, it does revert the portfolio back to a fixed proportional mixture and re-establishes our proportional capital bets. The simple act of rebalancing can even create returns from volatility pumping, whereby rebalancing systematically exploits randomness by buying low and selling high. Examples can even be constructed whereby an asset has a negative realized return, but is volatile enough that rebalancing allows us to profit from its ups and downs.
Below we plot a 60% S&P 500 / 40% Barclay’s US Aggregate Bond mixture (“60/40”) and a 59% S&P 500 / 39% Barclay’s U.S. Aggregate / 2% XIV portfolio (“59/39/2”). Each portfolio is rebalanced annually.
Source: CSI. Calculations by Newfound Research. Returns are hypothetical and backtested. Past performance is not an indication of future results. S&P 500 is proxied by the SPDR S&P 500 ETF (“SPY”) and the Barclay’s US Bond Aggregate is proxied by the iShares U.S. Aggregate Bond ETF (“AGG”). Returns are gross of all fees except for underlying ETF expense ratios. Returns assume the reinvestment of all distributions.
At the end of the day, despite losing almost 2% of the final portfolio value at the end of the period, the 59/39/2 outperformed by 82 basis points on an annualized basis. That is all not to say that rebalancing makes this a certain winning strategy. XIV very well could have gone to zero after day 1 and we’d simply be out 2%. It is a reminder, however, that while in isolation XIV may be Taleb’s turkey, investments generally do not exist in isolation. If we know our trade is akin picking up pennies in front of a steam roller, it might be prudent to set some pennies aside as we collect them.
From 11/30/2010 through 2/2/2018, XIV returned an astounding 41.5% annualized. Conventional wisdom says you should not look a gift horse in the mouth.
But at some point we should probably ask ourselves, “why do we think we actually deserve to earn 40%+ annualized forever?”
By shorting VIX futures, we are essentially earning a premium for providing insurance to whoever is long those futures. By being long VIX, they earn return when VIX spikes, essentially hedging against an increase in expected market volatility. The “premium” we earn is called the volatility risk premium and results from the inherent demand for insurance, which drives option-implied volatilities above actual realized volatilities.
But can 40% per year be a justifiable premium for insuring volatility risk? Consider that the equity risk premium and the bond risk premium have, historically, been in the low single digits. Now consider that the equity risk premium is payment for bearing risk that can manifest in drawdowns deeper than 50%. In fact, outside of the U.S., that equity risk premium has been compensation for markets that eventually crashed to zero.
Let’s address this by assuming that 40% is reasonable. Using round numbers, let’s assume there was $1 billion in XIV assets and $25 trillion in U.S. equity market capitalization at the beginning of the year. If we assume XIV continued to earn 40% annualized and U.S. equities earn 8% annualized, then XIV assets would surpass the entire U.S. equity market capitalization in just 40 years.
So we know that the game has to end eventually because the alternative is absurd. All along, there were really two ways this could have unfolded.
The first is that more and more capital pours into the trade, driving the premium earned towards zero. That’s probably the happy ending to this trade.
The second is that a tsunami of pain was eventually coming for us that would result in us achieving a much, much lower realized premium. And that’s what actually happened: several days of returns wiped out nearly a decade of premium earned.
In our opinion, the lesson behind XIV is not one of turkeys or defective Wall Street products. Rather, it’s simply that it costs little to assume the market is generally efficient and excess return is not risk free. In other words, when we earn a return, we should ask ourselves, “what risk did we take to earn this?” If we don’t know the answer, we probably should not invest there.
 Taleb’s turkey example is, by his own admission, simply a remix of Bertrand Russell’s chicken example that follows the same story and logic. Taleb used a turkey for “North American adaptation.”
 Assuming 0% return on cash, for convenience.
 “Average return” is almost never the right metric when talking about returns over time, but in this case it is appropriate because we are not compounding our wealth.
 After all, if the strategy were certain, we’d only expect to earn the risk-free rate!