Is SVXY broken? Should short Vol traders be worried?

VTS Community,

In yesterday's blog  (click here if you missed it)  I talked about how taking a buy & hold position on the -0.5x SVXY would be a roller coaster ride that even the highest risk tolerance investor would bail out on.  With two drawdowns over 70% that lasted many years on each of them, it's just way too much stress for anybody to handle.  They absolutely would pull the plug at the worst possible time.

Now, is buy & hold on the S&P 500 much better? 

Not really...  I can apply the exact same argument to the stock market.  It also suffered a 55% drawdown that took over 6 years to recover from.  Also, if we stretch that back to the 1990's, the drawdown after the Dotcom bust took 15 years to get back to break even.

Obviously nobody should be considering buy & hold on either:

Both completely unsustainable risk levels, but on a long-term basis the rate of return of the -0.5x SVXY is better than the S&P 500.  14.25% for SVXY vs 10.42% for the SPY.

If you want to see the difference that would make for a 30 year compounding period, it's actually quite significant.  Just getting that extra 4% would end up with basically triple the growth.

SVXY has been CRUSHED the last 6 months...

Since we do use the SVXY within our Tactical Volatility Strategy, many of you have asked me questions like, "Is SVXY broken?  Why is it down so much lately?"

It's definitely true, in the last 6 months the Volatility markets have been massively overreacting to every little blip in the stock market.  I'd have to go back through history and do some comparisons, but my best guess is this is probably the largest disconnect in the last 20 years. 

As someone who's been trading these products since they launched, I do remember all these crazy periods and this current one definitely gives me May 2012 vibes.  That was another period where (at the time) XIV way underperformed compared to what the S&P was doing.

Plotting the two on a chart though, it's insane how bad the SVXY has performed compared to the SPY in the last 6 months:

Now we use GLD Gold as our safety position during elevated Volatility, and given that we spent significant time in safety the last 6 months our own performance is far better.  I'll get into that comparison in a follow up blog, stay tuned...

Why is SVXY broken?

As far as an explanation, unfortunately the only thing I can point to is the fact that these are not equivalent positions and they can and often do deviate from each other. 

Often times people think that an SVXY position is essentially the same thing as a SPY position because they often do move in the same direction.  That somehow they are materially the same thing and can be used interchangeably.  They can not!

Volatility ETPs ONLY track the front two months of the VIX futures, and it's absolutely possible to see the VIX futures market trading distinctly different from the overall stock market.  Remember, in the VIX futures there's speculation, hedging, and many large institutions playing out their strategies in a variety of ways.

VIX futures are not a proxy for the stock market

One thing we can point out here is that the S&P 500 and the SVXY are only about 70% correlated long-term.  This means yes, they do move in the same direction as each other about 70% of the time.

That does mean 30% of the time they are inversely correlated:

We are quite clearly in one of those inversely correlated periods.  SVXY is down over 18% in the last 6 months, and the S&P 500 is up 8%.  And the full -1x SVIX is actually down almost 40% in that same time period.

Short Vol knocked down, but not out

There have been many periods in the past where people have declared the "Short Vol" trade dead.  The truth is though, it will never be dead because Volatility and all the various ways to represent it are structural to the global market itself.  As long as there is a stock market there will be Volatility markets underneath it.

The relationship between stocks and Volatility goes both ways and there are a roughly equal number of periods where SVXY outperforms the S&P 500 on a relative basis.  Our Tactical Volatility Strategy has capitalized on several of them to great success.  Unfortunately there are a few periods where it would have been better to either be in stocks, or just safety.  It comes with the territory. 

These periods tend not to last, and it wouldn't surprise me if the worst of it is about over.  Both the S&P 500 and the "Short Volatility" trade ebb and flow, and they do trade outperformance back and forth. 

We're just in a particularly dramatic market dislocation right now...