VXX: Where Wealth Goes to Die

by Daniel Putnam | July 9, 2012 8:40 am

Few ETFs have caused wealth destruction on the scale of the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[1]). Since its inception on Jan. 29, 2009, VXX has declined an astounding 96%. This year alone it’s down more than 57%.

But for some reason, investors just aren’t getting the message. VXX has logged an average daily trading volume of more than 51 million shares per day, which is more than all of the other 24 volatility ETFs combined.

The Siren Song of VXX

vxx 300x173 VXX: Where Wealth Goes to Die
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Like the Sirens from Homer’s Odyssey, VXX has lured no small number of unsuspecting victims onto its rocky shoals in recent years. So what’s the endless attraction of this ETF?

The answer lies in investors’ lottery-ticket mentality.

Every few months, VXX posts a gain in the 30% range when the CBOE Volatility Index (VIX) spikes. More famously, the ETF rose 153% during the market selloff that lasted from Aug. 1 to Oct. 3, 2011. These periodic rallies make VXX a continued destination for investors who are looking to express a negative view on the market. Why settle for shorting an individual stock or buying an inverse ETF when you can really go for the gold with VXX? The result is that the fund has been able to amass $1.9 billion in assets, even as it has lost almost all of its value.

The Problem With VXX

The horrific long-term performance of VXX isn’t a result of a collapsing premium[2] such as the one suffered by the VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX[3]) — VXX closed Friday at $14.26, just 1.3% above its net asset value. Instead, the problem is the contango in the “VIX curve.” The VIX quote shown on CNBC and financial websites is the spot, or front month, contract. Like any commodity, however, the VIX has various contracts extending out into the future. Currently, the curve looks like this according to data from CBOE.com:

Contract Friday’s Close
July 2012 18.25
August 2012 20.60
September 2012 22.30
October 2012 23.40
November 2012 24.30
December 2012 24.90
January 2013 26.50
February 2013 27.00
March 2013 27.65

Like most commodity price curves, the VIX curve increases as the maturity date becomes more distant — a condition known as “contango.” For VXX, this has represented a serious problem because the fund continuously rolls the first-month contract to the second-month contract as each month progresses. The result: The fund, by its mandate, is forced to sell low and buy high in perpetuity.

Since it is very rare for the VIX to go into backwardation — where near-month prices are higher than contracts further out the curve — contango is almost always going to be a problem for VXX. And all of this comes with a 0.89% expense ratio.

That’s Not All …

The inability of VXX to provide any type of long-term hedge against tail risk is well known, and advocates of the ETF will stress that it’s an instrument designed to take advantage of short-term increases in market volatility. However, a look at the history of the fund shows that it fails miserably on that count as well.

As can be seen in the table below, the fund has consistently delivered negative returns on 58.6% of the days since its inception. This is a function not just of contango, but also of the market’s tendency to decline more quickly than it rises.

Year % Down Days
2009 58.2%
2010 61.5%
2011 55.6%
2012 59.7%
Average 58.6%

Looked at another way, investors are laying 11-8 odds that they will make money in VXX on any given day. To bet on a football game, you only have to lay 11-10. In short, your odds of success are much better betting on football with your local bookmaker than they are trading VXX on a daily basis.

The Solution

The solution to the VXX problem is simple: Don’t trade it. The rewards for being right might be high, but the odds of success are too low to make it worthwhile. Keep this in mind if you’re thinking of taking advantage of the low VIX by going long in VXX.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  2. result of a collapsing premium: http://investorplace.com/2012/03/volatility-etn-tvix-rears-its-ugly-head/
  3. TVIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=TVIX

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