As seen in the following momentum table from Seeking Alpha, the ProShares Short VIX Short-Term Futures ETF (SVXY) has been on a recent streak of strong performance.
It is my belief that despite the headlines of wars and rumors of wars, SVXY is going to strongly perform in the foreseeable future and that a hedged position in the fund represents a good opportunity at this time.
SVXY is one of several instruments which give exposure in some form or fashion to the S&P 500 VIX Short-Term Futures Index. This index is provided by S&P Global and, as seen in its following track record, has simply destroyed wealth.
SVXY shorts this index at one-half leverage which is why its price generally increases most of the time. Since this index falls by around 53% per year, an investment in SVXY generally pays out.
So why does this index basically always fall? Glad you asked. This index is a quite unusual one in that it seeks to provide constant exposure in the VIX futures curve with a weighted-average holding date of 30 days into the future.
I’ve spent a lot of time studying forward curves as well as the instruments that track them and this specific methodology is by far the most bizarre I’ve personally encountered. Most strategies/ETPs/indices which follow futures curves tend to have a fixed window in which they will roll exposure from one futures contract to the next and over the period of a few days entirely shift exposure down the curve.
In the case of the S&P VIX Short-Term Index, this “30-day holding” thing means that from day one it is immediately shifting a greater amount of exposure into the second month futures contract since 30 days into the future will be a little beyond the expiration date of the front contract. And as a month progresses, it will be putting a greater and greater share of holdings into the second month futures contract to keep the exposure 30 days out.
If you’re at all familiar with forward curves, you immediately see the problem: roll yield. With this strategy, you are immediately exposed to roll yield, and as time progresses, it grows to represent a greater share of the returns of the index.
Roll yield is what you get from holding exposure beyond the front month contract in a futures curve. It arises from the fact that futures tend to converge towards spot. So if you have exposure in the second month futures contract and it is priced higher than the front month contract, in a typical month, it will decline in value in relation to the front. If the underlying prices of the instrument the futures track doesn’t go anywhere, this means that you will have lost money from the decline in value of the second month futures contract.
To graphically see this, here is the current futures curve for the VIX.
As you can see, the futures curve is solidly in contango (or back contracts priced higher than front contract). This means that roll yield is negative for a long position in the S&P short-term volatility index. Luckily for holders of SVXY, you are short this relationship which means that you’re making money from rolling.
In most commodities, roll yield is important, but generally not the leading driver of returns. In volatility, roll yield explains most of the returns over lengthy periods of time. Roll yield is almost the entire reason why this short-term VIX index drops by around 53% per year. To see this, here’s a long-term chart of these front two VIX contracts from VIX Central.
As you can see, on average, the price difference between these two contracts tends to hover in the 10-15% territory. This tangibly means that in a standard month, the second VIX contract generally will fall by an amount of some magnitude up to 10-15% in a given month in relation to the front contract. We can back into a rough guess on the typical loss based on the long-run return and say that in general, you’ll probably lose 4-5% or so of your holdings per month if you have a long position (~53% / 12) in the index which SVXY shorts at half leverage.
So that’s the good news – SVXY is probably going to increase by around 2-3% per month on default simply because it’s short a rolling relationship which has a proven track record of shredding value. The bad news, however, is this: the VIX can spike incredibly fast and strong, which is the reason most individuals likely trade the S&P VIX index in the first place.
If you go back and study the history of SVXY, you will see a few periods where it sees extraordinary drops in value in very short periods of time. This is because when you are trading the VIX, you are trading a “percent of a percent”. In other words, the VIX itself is quoted in percentage points (annualized implied volatility on a basket of S&P 500 options). And the futures contracts settle off of VIX values. So if you trade the futures contracts, you’re trading something which is giving you the return of holding a changing percentage point – which means you can see dramatic fluctuations in value.
To numerically frame this up, if the VIX were to jump from 12 to say, 18, in a given week, this would be a 50% change in value for VIX futures and a 25% loss for SVXY in a single week (remember, inverse, but at half-leverage).
For this reason, I believe that if investors are looking to capture the near-constant roll yield losses in VIX futures, they do so either through a bull call strategy or buy a put as protection against your position. In the long run, it is my opinion that this is a solid strategy and it will perform based on the nature of the market, but we can’t allow a single trade to blow us out of the water in the event that an outlier does occur.
All this said, I believe there’s a very good reason to hold SVXY right now beyond simply roll yield. Namely, the market remains in an uptrend.
The reason why this matters is that in general, a trend in place tends to remain in place. In other words, until we see significant volatility against the trend which breaks things like the 20-period moving average or the clear ascending trendline, it makes a lot of sense to keep a bullish bias.
If you’re wondering why this has anything to do with the volatility markets, it is because of the inverse correlation between market movements and the VIX.
As the market increases, the VIX tends to decrease. Given that we are in a solid and strong uptrend in price and that the trend is clearly intact, it is my belief that our market bias should be short the VIX until the trend proves otherwise. In other words, stay long SVXY to capture the weakness in volatility.
SVXY gives an inverse exposure to an index which has an annualized loss of over 50% per year for the last decade – a clear win for investors. There is serious tail risk to holding an investment in SVXY, so carefully consider a hedging strategy before purchasing. The market is in an uptrend – as long as the uptrend remains, it makes sense to be short volatility.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.