Thursday, January 27, 2011

The Skinny on XVIX

Of all the second generation volatility-based exchange-traded products that have been launched in the past few months, the one I find most intriguing is the UBS E-TRACS Daily Long-Short VIX ETN, which I prefer to refer to by its ticker symbol XVIX.

XVIX combines a 100% long position in the S&P 500 VIX Mid-Term Futures Excess Return Index with a 50% short position in the S&P 500 VIX Short-Term Futures Excess Return Index. It is therefore the functional equivalent of a position consisting of two units long VXZ and one unit short VXX. This combined long-short position nets out with very little exposure to volatility in most market conditions. Instead, XVIX is almost entirely a VIX futures term structure/contango play that increases in value when the slope of the VIX futures term structure is upward and/or getting steeper. On the other hand, XVIX comes under the most pressure when the slope of the VIX futures term structure is flattening or becoming downward sloping (i.e., entering into backwardation.)

While I was on a hiatus, Volatility Futures & Options put XVIX under a microscope in De-constructing XVIX and explored the historical data and the appeal of the 2:1 long-short ratio vis-à-vis a number of alternative ratios.

As I see it, XVIX is almost a pure play on the VIX futures term structure. The historical data provided by UBS and analyzed in some detail by Volatility Futures & Options shows annual returns in the 10-25% range prior to 2010, with a maximum drawdown in the 10-15% range. Last year has to be considered an outlier, as the mean daily contango as calculated by my proprietary VIX Futures Contango Index was 79, a huge premium over the lifetime average reading of 50 for this index. Not only was contango extreme in 2010, but it was also increasing for the majority of the year.

The bottom line is that 2010’s performance (up 55%, with a 5% maximum drawdown) in XVIX is not likely to be repeated any time soon. Over the long term, I expect XVIX to revert to annual returns in the 10-25% range. In the short-term, however, there may be some more significant bumps in the road as the VIX futures term structure unwinds some of its extreme contango and returns to a more consistently flat term structure.

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Disclosure(s): short VXX; long VXZ and XVIX at time of writing

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