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The cost of portfolio insurance.

June 07, 2010 | About:
..... the S&P 500 VIX Short-Term Futures™ Index TR offers exposure to a daily rolling long position in the first and second month VIX futures contracts..... The index futures roll continuously throughout each month from the first month VIX futures contract into the second month VIX futures contract.....


Sophisticated investors with a long-term view could use IPath S&P 500 Short-Term Futures ETN VXX to partially guard their portfolios against future downturns....


VXX is peddled as portfolio insurance to sophisticated investors with a long term view. Well, that rules me out. Your choice, do you put 1%, 5% or 10% of your portfolio in such an instrument ?

Up 30% in May... not bad ! Those with an insurance policy are glad.


Now let's look at the "book value" of VXX. Are we buying anything cheap and/or is there a chance the value will grow over time. Is there a margin of safety ?

It's clear from the desicription.... the underlying assets of VXX are VIX futures. The "company" called VXX sells this weeks volatility "insurance" contracts and uses the money to buy contracts for next month; they keep rolling the contracts over. If poeple are more worried about this week than they are about next month, this is a highly profitable business. We saw that happen in May.

The problem with this business model is that this weeks contracts are almost always cheaper. Not because poeple generally expect next month to be more volatile than this week, but simply because there is less demand for insurance against this weeks events. The market assumes this weeks risk is already in the prices.

In short, the underlying contracts become worth less at a rate of about 5% A MONTH for fundamental reasons. Don't take my word for it; look at the data: http://cfe.cboe.com/Products/historicalVIX.aspx and I'm not even counting trading costs.

I ask again, do you wan't 1%, 5% or 10% of your portfolio in an asset that is certain to be worth 50% less in a year. Just look at the value of VXX in June last year. Keep in mind that we recently had a spike in volatility so this is about as good as it gets for the business called VXX.

VXX was is not designed to track VIX; it is DESIGNED TO GO TO ZERO.... and the SEC is going after Goldman.

IMO VXX is an excellent short.

About the author:

I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. I can be reached at batbeer AT hotmail DOT com

Visit batbeer2's Website

Rating: 2.7/5 (6 votes)


GigaBubble - 7 years ago    Report SPAM
Always check AQS bid/ask before attempting to short futures-based or leveraged ETFs. You might be in for a surprise should they be available for borrowing and your short gets executed.
Sivaram - 7 years ago    Report SPAM

VXX is probably a terrible "investment" for anyone who isn't a short-term trader or a hedger. But I don't think it'll post -50% per year. I think most of the loss over the last year was due to the decline in the VIX, the underlying index VXX is tracking. You can see how VIX was declining until last month in this chart (VIX is the thin black line, the candlestick chart is VXX--note that the scales are not the same.) My guess is that VXX will probably post -25% if the VIX didn't decline so much.

I don't mean to detract from the article but...

Having said all that, batbeer does raise a good point for those investing in futures of any sort. One of the biggest jokes is USO, an ETF that tracks crude oil. The contango, which is similar to the behaviour batbeer is describing for VXX, has decimated anyone long the ETF for long periods. If you look at this chart, you'll see how USO has fallen more than 70% from the peak while crude oil has only collapsed around 50% ($140ish to $70ish.) UNG, USO's cousin that tracks natural gas, has been another money-sucking disaster (natgas went from $12ish to $4ish but UNG has gone from $60 down to $8.)
Buynhold - 7 years ago    Report SPAM
Good article, batbeer. VXX, like the short and leveraged short ETFs, is a ripoff.

Regarding portfolio insurance, my medium-term portfolio's equity exposure is hedged through the sale of Russell 2000 futures (I believe this index to be way overvalued); the cost of this "insurance" is typically around 1.25%-1.5% annually.
Batbeer2 premium member - 7 years ago
>> My guess is that VXX will probably post -25% if the VIX didn't decline so much.

I think this underestimates the downward driving force. Again, it does not get much better for VXX than this. At the end of May the VIX was at 48% percent or so. It is not often that the VIX gets this high.


In May of 2009 the VIX was at ~30%; it reached ~40% in May of this year. One could argue that the VIX has gained over the past 12 months. In the mean time VXX has lost over half its value.

What hights must VIX reach for VXX to lose just 25% over the coming year ? Will a VIX of 90% cut it ?

>> contango, which is similar to the behaviour batbeer is describing for VXX, has decimated anyone long the ETF for long periods.

Exactly !


Thank you.
Batbeer2 premium member - 6 years ago

It just struck me that I overlooked a major risk. This is NOT going to zero. Good thing I don't short......

Barclays just does a "reverse split". That's one way to take that "go to zero" option off the table.
Value_barbarossa - 6 years ago    Report SPAM
Don't think a reverse split is a major risk for a short position. If you short 100 shares, and then have 10 for 1 reverse split, then you just need to buy 10 shares to cover your position. I think it's a good idea, along with shorting USO and UNG.

you can even go semi market neutral by shorting the ultra ETFs on both sides of the aisle. I set up a practice portfolio like this...shorting sds/sso, etc. and the portfolio has posted nice gains so far without that much volatility.

The problem is whether it's economic to put on a long term short position in these ETFs. Think it depends a lot on which broker you use.
Batbeer2 premium member - 6 years ago
Yes.... just some fun.

I was tracking this to see where it would go and I didn't see the reverse split coming. I was expecting Barclays to take the product off the market and introduce something similar when the price eventually dropped to ridiculous levels.

The reverse split is of course much more effective. The risk is to my ego for failing to predict events correctly.

FWIW I chatted to a friend of mine who does do options shorts and stuff. I expected he was going to explain that shorting this would be very expensive so it would not be easy to make money..... the market can't be that inefficient !?

Well..... what happened is that he looked into it and immediately went short. He was surprised at the price he was able to get; he was above water within a month..... I believe he has the equivalent of june 2012 puts.

The trade would have gone against him only if VXX had dropped by less than 25% by june 2012. That, he thought was not going to happen. Neither do I.

Having said that, the VIX is not currently hitting new records so shorting VXX is more risky now than when I wrote the article.
Batbeer2 premium member - 6 years ago
VXX spikes today....

As explained in the article, VXX was designed to go to zero. You can invert this old short idea by going long XIV - VelocityShares Daily Inverse VIX ST ETN.
Batbeer2 premium member - 6 years ago
With volatility at similar levels now to what it was when I wrote the article, VXX managed to lose about half of its value. The effect of contango over time should not be underestimated.

If you (like me) don't short, XIV or IVO are worth looking at. Should volatility drop a bit from current levels, XIV and IVO will do spectacularly well.

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