We talk a lot here about the importance of risk adjusted performance metrics. In light of the recent “VOLmageddon” as it’s being dubbed I thought I would give you a real example of why paying attention to them is so important.
In my 5 part risk adjusted return series on YouTube I gave examples of the XIV vs SPY and showed that while the annualized rate of return of the XIV is substantially higher, actually the risk adjusted performance of SPY is more attractive and may mean that in the long run it will perform better.
* The numbers for SVXY are very similar, but I’m using XIV because that was the ticker used in my original videos.
The XIV launched on November 30th, 2010 at 10$ and reached a peak price of 145$ recently. I stated many times over the years (often times to ridicule and laughter) that I believe at some point in the future the XIV will see single digit prices again. Whether it took a couple weeks during a major S&P 500 correction or just a really bad day or two as we saw recently, I had no doubt it was going to see single digits again.
That wasn’t a market prediction or an attempt to see into the future, but whenever you see high absolute performance but poor risk adjusted performance, it means you’re dealing with an underlying asset that is very volatile and vulnerable to major drawdowns.
Given a long enough time horizon, at some point the true rate of return will reveal itself.
XIV vs SPY from the launch of XIV through mid 2017:
Through the first 6 1/2 years of it’s lifespan you can see that despite the XIV having nearly 3 times higher an annual rate of return, it’s Sharpe ratio, Ulcer Performance Index, and Maximum Drawdown were substantially worse than SPY.
* remember for Sharpe and Ulcer the higher the number the better, and for maximum drawdown the lower the number the better.
This is telling us that when we factor in the volatility or standard deviation from month to month, despite initial appearances the XIV is likely going to underperform the SPY in the long-run. Eventually that extreme volatility of performance would catch up and the true rate of return would reveal itself. Fast forward to today, of course we know that day has come.
XIV vs SPY from the launch of XIV through Feb. 15, 2018 (after termination)
Essentially what’s happening here is that because of the incredible return potential of volatility products, they tend to go on extended runs of exceptional performance, that are then occasionally interrupted by large drawdowns.
To see it visually, we can look at a product that did survive the Volmageddon, SVXY.
SVXY vs SPY since it’s launch on Oct. 4, 2011:
You can see in that chart there were several times where the SVXY accelerated in performance only to dip back down towards the S&P 500. In early 2012 it went back and touched the S&P performance. In late 2014 it got close, in early 2016 it got very close, and now recently in 2018 it’s gone below the S&P 500 again. I’m sure this game of back and forth will continue into the future. Amazing performance followed by larger drawdowns, and rinse repeat.
This is to be expected from a product that has substantially worse risk adjusted performance than the benchmark.
Now the great news is, we’re not buy and hold investors. We have three clever tactical volatility strategies covering the risk tolerance spectrum to navigate this volatility space.
And since volatility products have no problem going on tremendous runs of great profit when market conditions are ideal it makes them a great underlying product to invest in. However, given the potential for large drawdowns it does mean our singular focus must always be risk management. Of course we can’t eliminate the risk, but we can reduce it and may be able to boost long-term performance substantially.
With patience, a long-term focus, and a healthy amount of cash positions along the way whenever our input variables are ambiguous, we strive to be profitable for many years to come.
5 part Risk Adjusted Return series:
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