What started as a (mostly) innocent attempt on our part to highlight the multiplying canaries in the ETF coal mine, has recently morphed into a veritable crusade.
When it comes to low-cost, passive investment vehicles, that old saying about “too much of a good thing” certainly applies. The rampant proliferation of ETFs has created all manner of market distortions and it’s by no means clear that the underlying mechanics (the creation/destruction process) will function smoothly in a pinch. In fact, if we learned anything from August 24, 2015, it’s that there’s something horribly wrong with the technicals – even if no one has been able to nail it down with any degree of specificity.
But beyond that, there’s something profoundly frightening about ETFs and ETPs turning hordes of retail investors into derivatives and futures traders. That would be bad enough on its own, but it’s made immeasurably worse by the fact that the retail crowd doesn’t realize it.
Well, on Tuesday, Goldman is out with an exhaustive look at the “popular but often misunderstood” world of VIX ETPs and while we fully intend to give the note the proper treatment when we have time, we wanted to quickly highlight a few brief passages and show you a couple of visuals that should probably give you pause. Needless to say, this is a particularly relevant discussion in the current environment. Enjoy…
VIX ETPs are benchmarked to VIX futures; not the VIX When the VIX is at historically low levels there is a natural tendency to want to get long volatility and VIX ETPs have become an increasingly popular trading tool. But buyer beware. Not a single VIX ETP actually tracks the VIX. They track VIX futures and the return differential can be large.
Long vol: Strong gains during shocks; tough to buy and hold. Over half of the existing VIX ETP AUM is benchmarked to indices which track the daily return from being long a one-month VIX future. The long vol benchmark has fallen 99.9% since December 2005, for an annualized return of -46.1%. Long vol strategies are simply tough to hold for long periods of time. Why do investors continue to use them? Timely hedges perform very well: 1m VIX strategies were up by an average of 37.3% across the top ten calendar-month declines in the S&P 500 back to 2005.
Short vol: Up 4364% since March 2009. If longs have done poorly then it stands to reason the short has done well. The S&P 500 VIX Short-Term Futures Daily Inverse Index which tracks the return of being short a one-month VIX future was up 4364% from March 9, 2009 through 1Q 2017.
Contango: Why long vol performance has been poor. Understanding how VIX ETPs are created allows us to run forward looking return scenarios on ETPs like the VXX and explain why long vol performance has been so poor. Investors have lost an average of 83 basis points per day when the VIX curve has been in contango. That is not a fluke.
Most VIX ETPs are rebalanced daily, which means they track the one-day return of an index. By construction, that means that a long and a short can track their respective benchmarks perfectly each day but they may not be mirror images of each other over longer holding periods due to the compounding of returns. In August 2015, the 1m +1x benchmark was up 71%, the inverse 1m -1x was down -48%, while the double-levered 1m +2x was up 170%.
101: How big is the VIX ETP market? Over forty VIX ETPs were trading at the end of 1Q 2017 with an aggregate AUM of just over $3.7 billion, generating an average daily trading volume of $2.6 billion. VIX ETPs accounted for about 118 million vega per day over the first quarter of 2017 or about 22% of the total open interest in the VIX futures market, down from 33% in 2016.