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On Contango-Based XIV Trading Strategies

Summary In July 2014, Seeking Alpha author Nathan Buehler discussed a strategy where you short VXX when VIX goes from backwardation to contango, and cover when VIX re-enters backwardation. Buying XIV rather than shorting VXX is a very similar idea. The XIV version of Mr. Buehler’s strategy can be viewed as making a 1-day bet on XIV whenever VIX is in contango. VIX contango is a useful predictor of 1-day XIV growth. But historically a contango cut-point around 5% rather than 0% generates better raw and risk-adjusted returns. XIV is extremely risky (beta > 4), but trading strategies based on VIX contango appear promising. Background The VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) has had tremendous growth since it was introduced in late 2010, but has suffered major losses recently. (click to enlarge) The recent 11.9% dip in the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) coincided with XIV losses of 55.7%. XIV is still ahead of SPY since inception by a fair amount ($26.2k vs. $18.0k), but the extreme volatility of XIV makes it arguably an inferior investment (Sharpe ratio = 0.040 for XIV, 0.055 for SPY). In my view, XIV is a rather dubious fund to buy and hold long-term. It amplifies returns, but seems to amplify volatility even more, resulting in worse risk-adjusted returns than SPY. But trading XIV based on VIX contango – that is, the percent difference between the first and second month VIX futures prices (available at vixcentral.com ) – appears very promising. The purpose of this article is to assess the predictive value of VIX contango, and to assess and attempt to improve a strategy proposed by Seeking Alpha author Nathan Buehler. Data Source and Methods I obtained daily VIX contango/backwardation data and historical XIV and SPY prices from The Intelligent Investor Blog . Daily contango/backwardation is defined as the percent difference between the first and second month VIX futures. While the Intelligent Investor dataset includes simulated XIV data going back to 2004, for this article I only use the actual daily closing prices for XIV since its inception in Nov. 2010. I used R (“quantmod” and “stocks” packages) to analyze data and generate figures for this article. A Look at Nathan Buehler’s Strategy In the Seeking Alpha article Contango and Backwardation Strategy for VIX ETFs , Mr. Buehler suggests shorting VXX when VIX goes from backwardation to contango, and closing the position when VIX re-enters backwardation. The exact time frame for back-testing is a little unclear to me, but Mr. Buehler reported 221.09% total growth from ten VXX trades between May 21, 2012, and April 14, 2014. That is impressive growth. Then again, VXX fell 86.1% over this time period, and XIV gained 213.9%. So it’s a bit unclear how much of the strong performance was due to VXX tanking over the entire time period, and how much was due to the contango strategy providing good entry and exit points. I am not a short seller so I’m more interested in the “buy XIV” version of Mr. Buehler’s strategy. Let’s consider an approach where you look at VIX contango at the end of each trading day. If VIX has entered contango, you buy XIV; if it has entered backwardation, you sell XIV. If we backtest this strategy since XIV’s inception, ignoring trading costs, we get the following performance: (click to enlarge) The contango-based XIV strategy performs well relative to buying and holding XIV for the entire period, achieving a higher final balance ($57.0k vs. $26.2k), smaller maximum drawdown (56.3% vs. 74.4%), and a better Sharpe ratio (0.061 vs. 0.040). Looking at the graph, we see a major divergence in mid-2011 when selling XIV avoided a huge loss. However, there were many times where the contango strategy failed to prevent big losses. Note that buying XIV when VIX enters contango, and selling when it enters backwardation, is equivalent to holding XIV for 1 day whenever VIX is in contango. So this strategy is entirely dependent on VIX contango predicting 1-day XIV growth. VIX Contango and 1-Day XIV Growth For Mr. Buehler’s strategy to have worked so well over the past 5 years, there must have been positive correlation between VIX contango and subsequent 1-day XIV growth. There was indeed some correlation, but not very much. (click to enlarge) The Pearson correlation was 0.059 (p = 0.04), and the Spearman correlation 0.027 (p = 0.35). Note that VIX contango explained only 0.3% of the variability in subsequent 1-day XIV growth. But there does appear to be some predictive value in VIX contango. It’s a little easier to see when you filter out some of the noise and look at mean 1-day XIV growth across quartiles of VIX contango. (click to enlarge) Naturally, we’d hope that VIX contango has enough predictive power to pull the distribution of XIV gains a little bit in our favor. The next figure compares the distribution of XIV gains on days after VIX ended in contango to days after it ended in backwardation. (click to enlarge) The mean was higher for contango vs. backwardation, but the difference was not statistically significant (0.22% vs. -0.26%, t-test p = 0.37). Surprisingly the median was a bit higher for backwardation (0.50% vs. 0.86%, Wilcoxon signed-rank p = 0.62). Towards A Better Cut-Point Holding XIV whenever VIX is in contango is somewhat natural, but there’s no reason we have to use 0% as our cut-point. We might do better if we hold XIV when VIX is in contango of at least 5%, or at least 10%, or some other cut-point. Actually if you look at the regression line in the third figure, you can work out that the expected 1-day XIV growth is only positive for VIX contango of 1.65% or greater. Based on that, we actually wouldn’t want to hold XIV when contango is betwen 0% and 1.65%. Let’s compare 0%, 5%, and 10% VIX contango cut-points. (click to enlarge) The higher cut-point you use, the less frequent your opportunities to trade XIV, but the better the trades tend to be. Notice how the 10% cut-point rarely allows for trades, but tends to climb really nicely when it does. Performance metrics for XIV and the three contango-based XIV strategies are summarized below. Performance metrics for XIV and XIV trading strategies with various VIX contango cut-points. Fund Growth of $10k MDD Overall Sharpe Ratio Sharpe Ratio for Trades XIV $26.2k 74.4% 0.040 0.040 Contango > 0% $57.0k 56.3% 0.061 0.065 Contango > 5% $65.1k 37.3% 0.072 0.090 Contango > 10% $49.3k 14.9% 0.110 0.293 Total growth was best for a contango cut-point of 5%, while maximum drawdown decreased and Sharpe Ratio increased with increasing contango cut-point. (Note that “overall Sharpe ratio” includes the 0% gains on non-trading days, while “Sharpe ratio for trades” does not.) Of course we aren’t restricted to cut-points in 5% intervals here. Let’s play a maximization game and see what VIX contango cut-point would have been optimal for total growth and for overall Sharpe ratio. (click to enlarge) Final balance peaks at VIX contango in the 5-6% range, and is maximized at $100.4k for VIX contango of 5.42%. Overall Sharpe ratio is maximized at 0.115 for VIX contango of 9.95%. Sharpe ratio for trades is maximized at 4.231 for VIX contango at the highest possible value, 21.6%. Of course it wouldn’t make much sense to use a cut-point of 21.6%, as that number is hardly ever reached. Play Both Sides of the Trade? If sufficient VIX contango favors holding XIV, it seems that sufficient VIX backwardation would favor holding VXX. That brings to mind a trading strategy where you buy XIV when VIX contango reaches a certain value, and buy VXX when VIX backwardation reaches a certain value. Trading both XIV and VXX would provide more opportunities for growth. Indeed many of the analyses presented so far are similar when you look at holding VXX based on VIX backwardation. In particular: VIX backwardation is positively correlated with 1-day VXX growth. Regression analysis suggests that VXX on average grows when VIX backwardation is at least 0.38% (equivalently, VIX contango is -0.38% or more negative). Growth of $10k for a backwardation-based VXX strategy is maximized at $13.3k, when you hold VXX when VIX backwardation is at least 5.67%. Unfortunately, 33% growth over 5 years with VXX is nothing compared to 900+% growth with XIV. I experimented with strategies that use both XIV and VXX, but was unable to improve upon XIV-only strategies. Concerns One of my concerns with these strategies is that we’re working with a very weak signal. VIX contango explains about one-third of one percent of XIV’s growth the next day. Contango-based volatility trading strategies do appear to have potential, but keep in mind that VIX contango just isn’t a strong predictor of XIV growth. Another concern is that the excellent historical performance of these strategies may be driven by the bull market of the past 5 years. I think it is very possible that in a bear market these strategies might work poorly for XIV, and perhaps well for VXX. Each strategy involves holding XIV/VXX at certain time intervals, so of course they will be affected by the underlying drift of XIV/VXX. After all, the absolute best you can do with either version of the trade is the total upswing in the fund you are trading over a period of time. Finally, I have noticed in the past that XIV seems to have positive alpha when markets are strong, and negative alpha when markets are weak. This makes it really hard to do portfolio optimization, as the net alpha of a weighted combination of funds including XIV actually depends on what sort of market you’re in. I think an analogous problem could arise for contango-based XIV strategies. For example, holding XIV when VIX contango is at least 5% may only be prudent in periods when XIV itself is rapidly growing, which would typically occur in a strong market. And a strategy that only works during bull markets isn’t very exciting. Conclusions A variant of a strategy discussed by Nathan Buehler, where you hold XIV whenever VIX is in contango, appears promising based on backtested data since Nov. 2010. But increasing the contango cut-point from 0% to 5% increases total returns while also improving Sharpe ratio and reducing MDD. Going to 10% further improves the Sharpe ratio and reduces MDD, but sacrifices total growth as there are fewer trading opportunities. Since Mr. Buehler’s strategy is based on the idea that VIX contango favors XIV, increasing the contango cut-point above 0% makes a lot of sense. It allows us to trade XIV only when we have a substantial advantage due to contango, which reduces trading frequency and therefore trading costs. Strategies based on backtested data are almost always overly optimistic, and I suspect that this analysis is no exception. I am particularly concerned that much of the excellent historical performance is due to XIV’s positive alpha during the past 5 years, which itself was due to a strong market. Therefore, I probably wouldn’t recommend implementing these strategies just yet, at least not with much of your portfolio. Personally, I would consider freeing up a small portion of my portfolio for occasional high-conviction XIV trades based on VIX contango. For example, I might buy XIV on the relatively rare occasion that VIX contango reaches 10%.

Global X YieldCo ETF: Not Ready For Prime Time

YieldCos are a relatively new market entrant focused on paying dividends. Despite some popularity among income investors, they are, at best, untested. But that didn’t stop Global X from creating an ETF to track them. I have misgivings about exchange traded funds, or ETFs, in general. While a good idea on one level, Wall Street has a habit of turning good ideas into misused and abused ideas. Which is why Global X YieldCo Index ETF (NASDAQ: YLCO ) caught my attention. I’d say this ETF is a risky investment that most investors should avoid. Here’s why… What’s a YieldCo? So an ETF is a collection of stocks or bonds that trade on an exchange all day long. Sort of like a mutual fund, sort of like a closed-end fund. The ability to trade all day makes ETFs similar to closed end funds. But the market price for a closed-end fund can vary greatly from its net asset value. The structure of ETFs lead them to trade pretty close to net asset value, like a mutual fund. ETFs are also very cheap to own. There is, in fact, a lot to like about ETFs, so long as you stick to large, well diversified funds. But Wall Street, seeing a hot new product, has ramped up its marketing machine. How many S&P 500 ETFs do we need? Not many. Which is why ETFs have gotten more and more obscure, often targeting niche areas and risky investment approaches. Is there a place for these vehicles? Probably. Should average investors be putting their money in them? Probably not. Which is why a YieldCo ETF caught my eye. YieldCos are a relatively new business construct, dating back to around 2012. At this point, they are very similar to a limited partnership structure in which there is a sponsor company that sells its assets to the YieldCo. The YieldCo then spits out income to shareholders. The big difference is that the YieldCo is generally a regular company, so there’s fewer tax headaches than you would face with an LP which is structured as a partnership. On the surface this sounds great. The YieldCos in existence have generally owned electric generating assets with long-term contracts in place, so there’s even some ability to predict a reliable income stream. Investments in the renewable power space (solar and wind, for example) are most often highlighted, though YieldCos own other types of electric generation, too. Growth comes from buying more and more assets. Like LPs and REITs, however, YieldCos spit out so much income that they have to issue more shares to pay for additional assets. There’s nothing inherently wrong with this, since there are obvious precedents for the business model. However, that still doesn’t mean this relatively new business model will work out as planned. Moreover, the focus on renewable power projects means that YieldCos are tapping into a current investor interest. That’s great right now, but what if investors lose interest? So, by and large, I’d say that YieldCos have an interesting story behind them. But, and this is a big but, the long-term legs of the story remain untested. So investors should tread lightly in the YieldCo space, tempering a desire for income and income growth with a bit reality about the very short life most of these entities have lived. If you want proof of these risks, take a moment to look at the recent events around NRG Energy (NYSE: NRG ) and its YieldCo NRG Yield (NYSE: NYLD ). Diversify to reduce risk Of course, one way to offset the risk of owning just one or two YieldCos would be to buy a portfolio of them, right? And that’s where Global X’s YieldCo product comes in. It owns 20 of the largest YieldCos and provides a one-stop shop for getting diversified exposure to this potentially up and coming space. Wait… There’s some problems here. YLCO does own 20 stocks, but its prospectus explains a minor detail you’ll want to watch: “The components of the underlying index are YieldCos selected from the universe of global publicly listed equities, which have a minimum market capitalization of $500m and an Average Daily Value Traded (“ADVT”) over the last three months greater than $1 million. If less than 20 securities satisfy this criteria, the market capitalization and ADVT requirements are lowered. If there are still fewer than 20 securities, the parent companies of proposed YieldCos with the nearest anticipated listing dates will be included in the index until there are 20 index constituents.” In plain English that says, “We want to own 20 YieldCos but there aren’t that many of them right now. So we buy all that we can, even really tiny ones. Since that still may not lead to 20 holdings, we’ll buy companies that aren’t YieldCos but that have said they want to spin one off.” So YLCO has built a niche ETF in a sector that doesn’t have enough stocks in it to support a portfolio of 20 sufficiently sized companies. Think about that for one second. You are buying everything in the sector without any regard to whether or not it’s a good or bad company. With only little regard to size. All a company needs to be is a YieldCo, or a company that says it wants to spin a YieldCo off, to pass muster with Global X. Sure, you’ve got broad exposure to this relatively new niche, but is that really the way you want to get it? If the YieldCo sector continues to grow and manages not to implode, YLCO could become a useful way for investors to get diversified exposure to the space. So, on that level, it’s not a bad idea. However, the YieldCo space just isn’t mature enough at this point to support what YLCO wants to offer. And, in the end, conservative investors should avoid it. In fact, I’d go so far as to say that most investors should avoid it until the YieldCo space has grown some more and YLCO has been stress-tested by the market.

How Diversifying Can Help You Manage Market Mayhem

Summary Diversification is not simply about holding more assets. It is about paying attention to how the different parts of your portfolio work together. At its most basic, you have three components: stocks, bonds and cash. You may want to hold a blend of all three, depending on your goals. Four traits adding flavor to a balanced portfolio include quality, geography, sectors and styles and size. The recent market volatility, while not unexpected , has certainly been hard for any investor to digest. If you are feeling a tad queasy, you aren’t alone. It’s an apt moment to pause and remind ourselves of the importance of diversification to help your portfolio ride through market turmoil. What is Proper Diversification? While attempting to teach my youngest daughter about nutrition over the summer, I pulled up the nutrition wheel . As I showed her the various food groups, I was reminded of a diversified portfolio with all its asset classes. Arguably the most overused word in investment jargon, diversification is not simply about holding more assets. It is about paying attention to how the different parts of your portfolio work together. It’s part art and part science, like so many things in life, and takes some careful thought to make the right choices. Think of it like maintaining a balanced diet – one food isn’t going to give you all the nutrition you need. Asset Classes as Food Asset classes are your basic food groups – carbs, proteins and vegetables. As with food, each asset plays a different role. At its most basic, you have three components: stocks, bonds and cash. Stocks are generally riskier than bonds, but you can potentially see greater gains over time. When stocks decline, bonds have generally held up better and often delivered positive returns. And then there’s cash, which many investors use to preserve capital for a major expense, like college tuition. You may want to hold a blend of all three, depending on your goals. Simply a mix of individual company stocks and corporate and government bonds, however, may not give you everything you need to best manage risk and return. A balanced portfolio could also include a variety of nutrients and flavors. Four Traits of a Balanced Portfolio Quality For your bond portfolio, you’ll want to consider diversifying across credit quality – such as Treasuries, investment-grade and high yield – each of which has a unique risk/return profile. For stocks, you may want to focus on the quality of a company’s balance sheets and evaluate factors such as dividend growth, earnings or management. Geography It’s natural to have a home-country bias, and the U.S. is still one of the strongest markets in the world. But there’s no denying that we live in a global economy. There can be real benefits to expanding your geographic horizon to pursue opportunities in other regions and countries. Try to have a risk-balanced blend of investments across developed and emerging markets so you’re well positioned globally. Also, keep in mind that the value of the dollar against other currencies has become more important to your bottom line lately. So consider whether some currency-hedged exchange traded funds (ETFs) may help to protect your portfolio against sudden changes. Sectors And Styles Industries respond differently to different parts of the business cycle. For example, cyclical sectors, such as technology and discretionary consumer goods, generally benefit from economic upturns. On the other end, defensive sectors, such as food staples and utilities, are the last areas that people cut back on when times are tough. There are also certain styles of stocks to consider, such as value or momentum, and, for certain investors, some smart beta strategies may be an alternative to consider to help you access those styles. In short, cycles turn, so you probably want to make sure you’re not over-concentrated in one area. Size Everyone wishes they had invested in just the right tech company in the early 1980s, when the now-successful ones were just getting off the ground. But back then, who knew that personal computers would not only be in nearly every home like a TV, but might actually kick TVs to the curb? While it’s true that smaller companies can sometimes pay off big, they also carry higher risks. So you’ll want to consider a mix of small, medium and large companies. Many investors skew to the large side, unless you have the stomach for lots of ups and downs. Stay Diversified Until the End This may feel like a lot to manage, but it’s not as complicated as it seems. Many online resources and financial planners can break down your existing portfolio into a pie chart so you can see what slices you have. Then seek advice before making any changes. If you’re just getting started, internet tools can help you create a diversified core portfolio . Or consider a core allocation ETF , based upon your risk appetite and time horizon. As you approach your goals, you may need to reallocate your holdings. But that doesn’t mean that you should be less diversified. Make sure you always have an appropriately balanced diet of investments. This post originally appeared on the BlackRock Blog.