What went wrong with XIV?

By , CEO of Volcube.

What went wrong with XIV?

On the face of it, absolutely nothing! The VelocityShares Daily Inverse Vix Short-Term ETN looks set for redemption, with its shareholders likely to receive just a few cents in the dollar. However, whilst the dust may still be settling, it appears that XIV’s collapse has occurred precisely as was always intended. And that is when we compare its demise with the rather unappealing forecast made in the product’s own prospectus, on page 15….

“The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”


‘Investors’ cannot claim they were not warned. Whilst it was not inevitable that XIV would collapse to zero, over the long term it was highly likely. All that was required was for the VIX index to double in a day. Since this results in a 100% increase in the VIX, therefore XIV should deliver a negative 100% daily return. True enough, this has not really happened since the VIX has been officially published, nor for the period before that when it can be historically reconstructed (a total timespan of some 30 years). But it was clearly not beyond the realms of possibility for a doubling to occur.

The mechanics of the collapse seem to have involved the issuer deciding their stop had been triggered, at which point they looked to buy back tens, or even hundreds, of thousands of VIX futures. These short futures positions were held by the fund as the proxy for being short the VIX index (which itself is not tradable). Holders of XIV shares had seen the value of the shares rise several-fold over recent years as volatility remained low. The primary source of the asset’s rise however was the ‘rolling’ of the futures each month, as longer dated VIX futures were typically 10-20% higher in price than those due to expire presently. The fund would buy back the expiring future and sell the higher priced longer dated future. Thus the fund could accrue profits, month after month, sometimes even if volatility (i.e. the VIX) generally rose.

The execution of these futures in pretty spectacular size in the face of a falling stock market, almost certainly triggered more volatility elsewhere. In the aftermath of this collapse, it seems very likely that the regulators will take another look at volatility ETNs. Firstly, since plenty of retail investors will have, yet again, been wiped out using what are essentially complex 2nd or 3rd order derivatives wrapped up a respectable-looking exchange-traded products. SPY or HYG, volatility ETNs are most certainly not. Secondly, these products are clearly structurally troublesome to the wider market, when in distress. Any derivative should derive its value from something else; preferable something bigger. Whenever the derivative tail starts wagging the spot product dog, a nasty feedback loop can occur. This may well have happened in this instance; stocks falling leading to the VIX spiking, leading to XIV getting into trouble, leading to the VIX spiking, leading to stocks falling more etc…The cause and effect direction is speculative and debatable, but it is very hard to argue that these products can trade in a vacuum when, by definition, they are pointing at each other.

Why would anyone have been long XIV?

Was being long XIV, or other short-vol ETNs, a ridiculous position? The knee-jerk answer is yes. However, the profits in recent years have been significant from being long such products. Anyone who top-sliced, or took large dividends from similar products such as VMIN, may have escaped less scathed than late comers to the party. The doubling ‘in a day’ of the VIX may not have occurred for years to come, in which case these products may have still rallied even in the face of the a VIX rally, due to the roll-effect. And presumably if anyone was holding these products as a hedge against volatility remaining low, then the ‘position’ they were hedged against, one hopes, has gone their way, since volatility has undoubtedly spiked. Nevertheless, it is hard to argue the case for a product that has just collapsed to near-zero, just as its issuers seemed to promise it would! And one suspects that any regulator taking a further look at these products may reach such a conclusion. They may find they receive support in that view from the wider ETP/ETF industry, many of whom are wary of being tarnished by association with products that are far removed from a vanilla stock, commodity or bond index tracking retail-friendly offering. Time will tell.

About Volcube

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