I spend a good chunk of everyday just data mining and number crunching. Boring stuff to most, but to me it’s one of the most interesting parts of my job.
So you’ve heard me talk about the low end of the volatility spectrum not necessarily being the most advantageous when it comes to profiting from investing in volatility products like XIV, SVXY, VMIN, etc. There’s always exceptions to the rule and clearly 2017 is an outlier, but for the most part there’s reasons why I talk about that. Now everyone has their own style and I’m certainly not saying there is only one way to do this, but there is only one data set so exercises like this are meaningful.
Now there’s no question that the strength of the volatility risk premium doesn’t break down at low volatility levels, and if anything that’s where some of the strongest levels reside. If you look at the VIX futures term structure when volatility is very low you’ll notice the levels of contango are usually quite high.
However, there’s some opposing forces at the low end. For simplicity in this blog we will call it “volatility mean reversion” or “momentum of volatility” that may counteract some of that VRP harvesting. So the question becomes:
Which force is stronger? Does the steep term structure at low vol levels outweigh the natural mean reversion that exists in the volatility space?
To answer this question, what better way than to look at actual live trading performance for the XIV itself since inception on November 30th, 2010. So what I’ve done is broken down the VIX Index levels into quintiles and then shown the actual live XIV performance in those sections.
* Now of course the VIX Index is just one cog on the volatility wheel so it shouldn’t be taken as the be all and end all, but we do need a volatility metric to divide the market so the VIX Index will suffice:
So we can see quite clearly where the bulk of the XIV’s insane performance in the last 7 years has come from.
The 20-40% quintile and the 40-60% quintile are by far and away the best sub sections of the volatility market when it comes to the inverse volatility ETPs. Our main VTS Tactical Volatility Strategy plays in this range also. We have averaged trades on about 43% of days, right in the heart of this most profitable range and the rest of the more ambiguous and lower performing sections I prefer cash.
It won’t come as any surprise to anybody that the highest 20% (red line) has some poor performance. This is when the markets are clearly melting down and volatility metrics are flashing warning signs. It’s no surprise that XIV doesn’t perform well during those periods and in fact, that’s when we will start to dip a toe in the long volatility VXX pool.
But perhaps something that will surprise you is the equally bad performance in the bottom 20% quintile. Remember, this is when the VIX futures term structure will be strongly in contango and all those articles you’ve read in the last year or two are telling you to buy with both hands, and maybe the hands of your dog as well. There’s a lot of leveraging and risk taking going on.
But historically the XIV is actually negative in it’s entire 7 year life span during those periods. Is it possible that some of those articles that recommend logging into VIXCentral.com every morning and following the VIX term structure may be wrong? Or at the very least, inadequate?
I feel like 2017 has skewed a lot of perception. It’s the exception to the rule. This year has seen record smashing low volatility for a longer stretch than we’ve ever seen, so not surprising that the more XIV you bought the better you did. But over 7 years that is absolutely not the case, and going back further over the past 20 years that would only have been true in maybe 2 or 3 years. Most other years when volatility is normal, these products require a lot more nuance.
Since most people entered the volatility space within the last 2 years and have never live traded through even a single drawdown, perhaps they are ignoring a giant swath of the data we have?
Since I’m an investor who is 100% data driven, 100% systematic and quant based, this may explain why we’ve been in cash for most of the year. Aggressive strategists have been rewarded by the record low volatility and good for them. For one year in seven that’s been the way to go. But for the other six years (and maybe future years) not the case and I would imagine some of them are going to be a little surprised when the markets normalize.
Just my 0.02$
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