Read this excellent post from Don’t Fear the Bear: XIV and the Whipsaw Regime.
DFTB shows 3 simple strategies trading the inverse VIX ETN XIV.
In all 3 cases, buying XIV in the face of “strong” volatility, which would have performed abysmally in the past, has worked very well the last 1+ year. DFTB’s backtests are below (click to zoom). Compare strategy results since 2007 to those since 2012.
Building on that observation, I’ve shown in tests on this blog how many common VIX ETP strategies have lagged over the last 1+ year, because they’re moving to a defensive posture in cash or long volatility (ex. VXX) just as short vol. (ex. XIV) is bouncing back like a coiled spring (matching what we see in DFTB’s tests).
What may have been warnings signs of impending doom in the past, like a backwardated term-structure, negative VRP estimates, or spiking volatility (to name but a few), have consistently been met with a rebound in short vol.
I think the cause of all of this is very simple, and not related (or at least mostly not related) to these strategies becoming less effective. It’s simply a result of rarely seen strength in the S&P 500 (with the S&P 500 and the VIX of course being inversely related).
To illustrate, the charts below show VFINX (S&P 500) since DFTB’s test began in 2007. The period since mid-2012 when many strategies began to lag is highlighted in orange.
During this orange period, the S&P 500 has returned 25% annualized with a Sharpe Ratio of 2.7 and a max 1-year drawdown of just -9.6%.
Those numbers are way outside of historical norms. By my count, the market has exhibited the level of consistent strength we’ve seen over this period in less than 8% of historical periods of similar length.
When the market is showing this type of strength, any answer other than long XIV to the teeth is the wrong answer, especially after XIV shows a bit of weakness (because like a coiled spring, it bounces back with a quickness).
But over the long-term the strength the market is exhibiting is, by its very nature, not sustainable. The market will return to normal where cautiously stepping out of XIV, ZIV, etc. during strong volatility is the right answer.
In other words, these strategies are not broken, they’re just designed for more “normal” markets, and the market of the last 1+ year has been outside those historical norms.
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Two other notes:
- This all reinforces the importance of backtesting VIX ETP strategies back to 2004, rather than simply when VIX ETPs launched (read more), because recent history is not representative of how VIX ETPs will perform over the long-term.
- None of this may apply to very short-term strategies where the broader trend of the market isn’t as important. In addition to our strategy here at VMS, I also trade a much faster-paced strategy that has been mostly unaffected by this market. There are not enough publicly disclosed short-term strategies like this to draw a broader conclusion about what other traders are experiencing, but based on my own personal experience, it should be noted that these types of strategies are entirely different animals.
Volatility Made Simple