SVOL - SVOL: High Yield And Low Correlation To Other Assets

2023-08-17 21:22:28 ET

Summary

• SVOL generates yield by shorting VIX futures and hedging its short position with call options.
• SVOL has low volatility, high yield, and a low correlation with most other assets.
• Over the last year, the fund has suffered a price decline of 3.11% but is up 15.34% on a total return basis.
• I currently rate SVOL a Buy.

Thesis

I have been researching high yield ETFs for use in a margin portfolio, and the Simplify Volatility Premium ETF ( SVOL ) has recently caught my attention. After looking over the mechanics behind how it generates yield, I currently rate SVOL a Buy.

SVOL Fund Background

SVOL seeks to generate yield by shorting VIX futures. It also gains exposure to VIX calls to mitigate the risk of moves against its short position. Including fees, the fund has a total Annual Operating Expense of 0.66%.

Nav Erosion

Because it generates yield by shorting VIX futures, the SVOL moves inversely to the VIX. Also because it hedges its short position with call options, SVOL experiences significantly muted moves and has much lower volatility than its underlying.

Over the last year, SVOL has suffered price decline of 3.11%.

However, when looking at it on a total return basis, SVOL is up by 15.34%.

SVOL Specific Risks

A discussion of SVOL risk is not complete without covering Volmageddon . In February of 2018, markets experienced a downturn which spiked volatility and caused catastrophic losses for short volatility strategies. Because of the nature of markets, future volatility spikes are inevitable. The next volatility spike is already being referred to as Volmageddon 2.0 . My impression is that most of the cause of the event was due to a rush to close positions and settle in the aftermarket, which caused the VIX to continue spiking after normal trading hours. I wish I had more insight as to what steps have been taken to ensure that such an event cannot happen again. Because SVOL's goal is to harvest income and not to try to maintain correlation, and they have hedged their risk through call options, they do not suffer from this risk in quite the same way that most short VIX ETFs do.

SVOL has only been trading since May of 2021. The last major volatility spike was in early 2020. This means we do not have the ability to look back at historical data to see how SVOL performed during the last major spike. SVOL hedges its short position by purchasing VIX call options. It is a fair assumption that these calls are specifically chosen to correctly hedge against dramatic moves, but we have yet to see this prove itself through a major event. Until SVOL experiences such a situation, and the hedge is provided with an opportunity to prove itself, we have to consider the possibility that its behavior might not match expectations.

Because they are shorting futures, at least some of SVOL's yield is generated from the difference between implied volatility and actual volatility. I believe we can expect SVOL's Yield to be higher during times when volatility is higher; this also means low volatility is likely to lead to lower yields.

The Hedge

By taking on a position which moves inversely to SVOL we can mitigate most of its volatility. Leveraged ETFs are designed to move according to the daily performance of their underlying. If they drop by 10% on any given trading day, they would then need to go up by 11% the following day to reach their previous value. If they drop by 50%, they would then need to double. However, their underlying does not suffer from the same behavior. Because of this, leveraged ETF's sacrifice the ability to maintain correlation over longer timeframes and suffer from long-term decay.

Their long-term behavior has been misunderstood by enough retail traders that the SEC and FINRA both issued warnings. Because of their high beta and long-term decay, it is incredibly unwise to be long a leveraged ETF over longer timeframes.

Because of these factors, I prefer to short leveraged ETFs. However, this carries its own risks. While its long-term NAV decay is working in ones favor, the annual cost to borrow fees are working against the position. Anytime the cost to borrow fees are above the rate of decay, the position loses value.

SVIX Fund Background

Volatility Shares' -1x Short VIX Futures ETF ( SVIX ) is designed to correlate to the performance of the Short VIX Futures Index on a daily basis. The index is calculated daily at 4:00 p.m. EST, and at a value calculated from the average price for the futures contracts between 3:45 p.m. and 4:00 p.m. This is notable, as it seems to remove the fund from the risk of low liquidity in the aftermarket, causing it to suffer from another Volmageddon. The fund carries a gross expense ratio of 1.47% and Fintel does not currently list their average borrow fees.

Over the last year, SVIX has risen 94.28%.

Over that same timeframe, the VIX has dropped significantly.

The VIX has dropped so far that it has returned back into pre-pandemic levels.

Because volatility is currently quite low, I believe the contraction that it has experienced is unlikely to continue over the next year. Because I view the current VIX values as low, I doubt SVIX has much more upside left in it.

Correlation

Because they are both tied to the same underlying market, SVOL and SVIX are highly correlated over shorter timeframes. SVIX is far more volatile than SVOL and so will only require a relatively small position size to achieve minimum variance.

When comparing the two over a longer timeframe, it's clear that they are expected to diverge significantly.

My minimum variance calculator is telling me that a variance of 0.100 can be achieved if SVOL is weighted at 90.74% and the SVIX position is weighted at 9.26%. To achieve this, one would need to short SVIX by $102.08 for every $1000 they have in SVOL. This will need to be rebalanced regularly, so anyone wanting to try this should build their own calculator in Excel.

Conclusions

Unlike most of the low-variance couples I have been able to set up, I had trouble comparing both assets to the same underlying. I am usually able to produce rough estimates for their separate NAV erosion rates so I can subtract their expected net pace of decay from expected yield to produce a rough estimate for total returns. Also, I was unable to find data on average borrowing fees for SVIX. Plus, SVOL is already hedged internally through call options. For these reasons, when the time comes for me to test out this high-yield portfolio I have been researching, I may choose to incorporate SVOL without its own volatility hedge.

I do not currently have any exposure to either SVOL or SVIX, and I do not plan on gaining exposure in the immediate future. However, SVOL is a high-yield, low-volatility asset. It is basically uncorrelated with most of the other high yield ETFs I have been researching. I believe incorporating it into my portfolio will help produce a more attractive efficient frontier. Although I still have questions centered around its final weighting, it will almost certainly make it into the first test run of the portfolio.

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