Tag Archives: seeking-alpha

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.

In Defense Of Market Timing (Sort Of)

Summary Typical studies that demonstrate why market timing is a bad idea have a fatal flaw: They’re not so much “market timing analyses” as “perfect market mis-timing analyses.” The options market gives us a feel for how to recast the problem. Some practical thoughts on actual pros/cons for market timing. We’ve all seen the studies, and the conclusions are the same: it’s not about tim ing the market, it’s about time in the market (tell that to the Japanese). I’d like to discuss why there are fatal flaws in the classic study put forth to investors, a study which seemingly demonstrates why market timing is a bad idea. But before going further, I would like to point out that I am attacking the typical anecdotal study, not the overall advice. This piece is not an endorsement on market timing. First, I present the typical kind of reasoning that is set forth for why one should never attempt market timing. This is one particular case, but there have been many variations presented throughout the years, and most investors have been exposed to one or more of them. From Horan Capital Investors : Making ill-conceived market moves can reduce the growth of one’s investments substantially. The below chart graphs the growth of the S&P 500 Index from 1990 through June 30, 2015. The blue line displays the growth of $10,000 that remains fully invested in the S&P 500 Index over the entire time period. The yellow line shows the same growth, but excludes the top 10 return days over the 25-year period (6,300 trading days.) By missing the top 10 return days over the 25-year period, the end period value grows to only half the value of the blue line that represents remaining fully invested. (click to enlarge) Chart source: Horan Capital. Wow! Pretty compelling. Missing out on just the top 10 days out of 6300 cuts my total return in half! Market timing must be a terrible idea, right? There are many very legitimate reasons to argue against market timing, and I’ll discuss some of them in the conclusion. But first, let’s dig deeper to see if there’s anything interesting taking place during those 10 “best” days. Indeed, the cumulative return for participating in those 10 best days amounts to 100% – but look at the dates! The dates these earth-shattering returns occurred teach us some valuable lessons. Two of the dates were March 10 and March 29, 2009 – the furious beginning to the new bull market. It would indeed be tough on an investor to miss those dates, as the train was leaving the station. Bull markets often begin with strings of giant gains, and as such there probably should be some plan to get back in if you dumped your stocks and have plans to rejoin. On the other hand, eight of the dates were merely bursts with plenty of room left for the market to fall. If you got out – and stayed out – the day before any one of those great days, for 3+ months, you’d have been very happy that you had missed both the huge rally as well as the ensuing freefall. In fact, if you got out just before the 9/30/08 5.25% gain, you could have stayed out for the next three years and not lost out on a penny of gains, even though 2.5 of those three years were part of the new bull. Big up-days happen when there is outsized volatility. The trouble I have with studies like the Horan study is that they effectively show you what would have happened if you were an absolutely perfect market mis-timer. Now granted, haven’t we all felt like we were perfect mis-timers? I sure have, and I’ll bet you have too. But this study – and multitudes like it – actually quantify for you how costly being a perfect market mis-timer would be: in this case a doubling of your capital. To further understand why the Horan study asks the wrong question, let’s invert it: How much more money would you have if you only missed the ten worst days in the market? Here they are: Missing the worst ten days in the last 25 years for the S&P would have more than doubled your money! Furthermore, nine of those ten times (1997 excluded), you could have gotten out after the bad day, and still have been happy for several weeks or months to come – even though you would have missed some monster rallies along the way (consider how closely the best and worst days are clustered). Taking aside taxes, transactions costs, and the like, if you could side-step the best ten and worst ten days, you would have been better off to have missed both. Participating in all twenty of those spectacular days cost you 7% cumulative of your ending balance. This is likely not just a fluke, as the stock market has long been known to exhibit negative skew, where the log-magnitude of big down-days are larger than for big up-days. The options market lends insight on the matter. (click to enlarge) Look at the VIX prints for the close of each of the prior days. If we plug those VIX levels in for a one-day option price calculator, struck at the close the prior day, we obtain the call price column. I’ll add that there’s a very good chance that the VIX would have been in backwardation during many or all of these dates, and so the actual call premium would likely have been higher still. If you had hedged your SPX holdings by selling a one-day, ATM call against your position, you would have reduced your SPX winnings relative to not hedging at all. But you would have earned 16% in total call premium, and as such the missed opportunity would have netted to 72% rather than 100%. This highlights two big ideas that are each worthy of note. First, if you sold a one-day call just before one of these hall-of-fame days, then you had some terrible luck: you sold a lot of gamma one day before a giant move. But notice that the options market was at least pricing in very large swings in all ten of these cases. Your missed opportunity, while still large, was dampened considerably. Put differently, your missed opportunity was unfortunate, but predictable. Second, I think framing the study in terms of the ultimate unlucky options trader demonstrates just how unlikely being a perfect market mis-timer really is. Think about it: what are the odds that you would sell one-day ATM calls, ten times in your entire stock-holding career, with each instance being met with one the ten best days in the last 25 years? ZERO! But that’s the same likelihood that you would just miss only the ten best days, and nothing else (forget the options). What if you sold a one-day, ATM option every day, including on some of those worst days? Perhaps the 72% you had missed out on would largely (or more-than-fully) be recouped. Conclusion Studies of the Horan variety above are simply not serious studies of market timing. It doesn’t mean that they don’t offer insight, but they give it in a way that clouds a greater reality. Being a perfect market timer would be amazing — but that alone is not a reason to attempt it. Likewise, being a perfect market mis-timer would be horrific, and that alone is no reason why you should avoid it. There are good reasons for avoiding market timing, but they have nothing to do with the study (quite the contrary; I’d argue that the study recommends running to high ground early and waiting for the dust to settle). Here they are: Transactions costs: lots of portfolio churn needs to be carefully considered. You need to think about what the broker, and what the market maker, is earning off your trade. It does not mean you shouldn’t trade, but it is undoubtedly a con rather than a pro. Taxes: tax losses are treated asymmetrically from tax gains, which skews your after-tax risk profile. That is a perfectly legitimate reason to avoid “market timing”. Psychology: This is by far the biggest reason investors shouldn’t time the market. Investors and traders are not the same animal. They have different skill sets, different perspectives, different goals. Traders time the market almost by definition. Most fail, and a few do quite well. Investors should not be market timers precisely because being a market timer has a lot in common with being a trader, and very few investors are good traders. Imagine morphing from being an investor (something you might be good at) into being a trader (something you are probably bad at) at the worst conceivable time. Look at those dates for the best 10/worst 10 days – what a nightmare! Is that the kind of environment where you want to consider shifting away from what you do know toward what you do not know? This is the real reason that investors should not attempt to time the market. Finally, when SHOULD an investor open or close a position in a meaningful way? I mean, couldn’t we describe any buy or sell order market timing of sorts? Is it part of your overall strategy? Do you have a lot of cash – waiting for weeks, months or years to get in, and then when the market falls, you get out? That’s undisciplined selling: that’s an investor acting like a trader. Note from the discussion above that there’s an outstanding chance that your “trade” will go well and you’ll be happy you panicked, at least for awhile. If that’s you, you should be asking: “When do I plan to get back in? Proverbially or literally speaking, what put option will I sell TODAY to lock me into getting back in should the market actually fall that low and I lose my nerve?” On the other hand, maybe you are selling because this is part of your discipline. “Ride my winners, cut my losers.”; “I don’t hang around in high-vol environments hoping for a recovery (they don’t all end with a V-bottom!)”. This is a legitimate reason to “panic” and sell: it’s part of your strategy. While you might be unhappy if the market rebounds, you did the right thing, even if you got the wrong result. Maybe you should tweak your strategy, ex post. Maybe the market is showing you that your strategy has some meaningful flaws that you never considered or took seriously. Reducing your position size – even to zero – could be prudent. It’s one thing when markets are going from bad to worse and it’s part of your discipline. It’s quite another when you never foresaw the eventuality that you’re in, and volatility is heavy on the market. You’ll know this to be the case when you are asking yourself – as an investor – serious questions about your own long-term investing style. You’re not considering “a trade”, you’re considering a change. Best of luck, I hope the bulls need it!