JJG - VXX: Too Late To Be Scared

2023-03-15 10:01:13 ET

Summary

• While investors in the banking sector panicked in the past few days, those that held shares of VIX funds like VXX smiled ear-to-ear.
• The iPath Series B S&P 500 VIX Short-Term Futures ETN is an "anti-fragile holding" that generally does best when the S&P 500 performs poorly.
• However, for structural and timing reasons that I explain in this article, I believe that VXX is a sell today.

With the blink of an eye, propelled higher by the SVB Financial Group ( SIVB ) and regional bank crises, the VIX climbed nearly 40% in the short three-trading day period that ended on Monday, March 13. Those that owned the iPath Series B S&P 500 VIX Short-Term Futures ETN ( VXX ) or a similar fund that tracks the fear index must have smiled ear-to-ear.

But those that did not already hold VXX shares are probably better off staying away from it, for now. Below, I explain why the exchange-traded note ("ETN") is likely to create losses even in the short term, let alone over a longer period.

VXX: short-term bet on panic

The VIX Short-Term Futures ETN is an "anti-fragile holding" that generally does best when the S&P 500 performs poorly. During the COVID-19 bear attack of February and March 2020, for example, VXX climbed an astonishing 400%-plus in a matter of 20 trading days. See chart below.

VXX is able to do so by seeking exposure to VIX futures contracts that expire in the next month or two. Currently, the ETN is allocated 75% to the April contract and 25% to the March one. As time passes, the holdings are rolled over to the following month.

The fund charges an annual fee of 0.89%, which is both high and largely immaterial relative to the ETN's mind-bending historical volatility of 76% annualized. VXX trades very frequently, at about 2.5 million shares per day, which is an important feature for an instrument that is mostly used for ultra-short-term bets on the direction of risk and/or outsized movements in the S&P 500 (SP500).

Two reasons why VXX is a sell

Having said the above, VXX can be a great vehicle for day traders that know how to read (and have been successful interpreting) minute-by-minute or hour-by-hour charts.

On a daily basis, the ETN tracks the movements in the VIX index very closely. The chart below shows the trading day changes in the fear index plotted against the movements in the share price of VXX since the latter's 2018 inception. The relationship is not one-to-one, and should not be expected to be so, due to the fact that the ETN's performance is tied to VIX futures, not the index itself.

Other than for near-term speculation purposes, buying VXX today and holding for much longer than a day is probably a bad idea for structural and timing reasons.

Structurally, VXX is designed to lose money over time. This is evident in the graph below that shows the value of $1,000 invested in VXX at inception declining to $117 today (blue chart). The "decaying" of the fund is not a fluke and is due to negative roll yield . In simpler terms: when the VIX curve is in contango, which it almost always is, VXX will consistently buy the long-dated VIX contract at a higher price than what the fund will eventually sell it for when it is time to roll over the position.

From a timing perspective, it is worth noting that the VIX index is mean reverting. That is: if the VIX rallies, expect it to correct eventually. If it sinks to historical lows, expect it to spike at some point, when the stock market finally panics. Likewise, if the S&P 500 has displayed weakness recently, the VIX has probably already rallied, and the next move is likely going to be lower.

VXX behaves somewhat similarly, after adjusting for the effects of the negative roll yield mentioned above. The bar chart below shows that the comparable fund ProShares VIX Short-Term Futures ETF ( VIXY ), used in this study due to it having a longer track record, has historically returned -8.5% at the median (or -3.5% on average) on any given month since its inception. But the monthly returns have been better at -4.1% (or -1.4% average) when the S&P 500 had spiked by +5% or more in the previous month. Conversely, VIXY's monthly returns have been worse at -12.2% (or -5.2% average) when the S&P 500 had sunk by -5% or more in the previous month.

In summary: if an investor wants to time the purchase of VXX well, he or she probably has a better chance of succeeding by going long when the S&P 500 is cruising — roughly speaking, when not many people are thinking much about hedging risk away. This is not the case right now, as the banking crisis has already reignited fears in the market. As of the close of trading on Monday, March 13, the VIX index at nearly 27 was back at levels not seen since October 2022.

For structural and timing reasons, therefore, I believe that VXX is a sell now.

For further details see: