On February 8th, I discussed the use of the inverse VIX ETP (XIV) to collect the roll yield from the VIX futures. When stocks fall and volatility rises, however, such a naked short position drops drastically. From 4/2 to 4/10, XIV dropped from 12.29 to 9.94, and lost 19% of its value (it’s now back to 10.37).
S&P 500 VIX Futures Term Structure Index (“Term Structure Index”) models a quasi-volatility neutral strategy that collects roll yield by exploring the difference in betas (to the VIX spot) along the VIX futures curve.
The Term Structure Index is a composite index that measures the return from taking a long 100% position in the S&P 500 VIX Mid-Term Futures Index Excess Return (“Mid Term Index”) with a short, or inverse, 50% position in the S&P 500 VIX Short-Term Futures Index Excess Return (“Short Term Index”), with daily rebalancing of the long and short positions. UBS E-TRACS Daily Long Short VIX ETN (Ticker: XVIX) tracks this index. XVIX returned 9.4% in Q1 2012.
Why does this strategy work? The strategy works based on two observations along the VIX futures curve:
1 – Since 12/20/2005, the Short Term and Mid Term indices have a beta of 47% and 23% to the spot VIX, respectively. So the beta of the Term Structure Index is close to zero.
2 – On average, the daily roll cost of the Short Term Index is around 0.18% while the daily roll cost of the Mid Term Index is 0.07%. So the Term Structure Index collects 0.02% roll yield every day on average.
Does this strategy work all the time? No. When the VIX futures curve is in backwardation, as what we saw in Q3 2011, the Term Structure Index tends to lose money.
For the majority of its history, however, the Term Structure Index shows a steady stream of positive returns at reasonable volatility. In Q1 2012, when the VIX futures curve was in deep contango, the index returned 6.16%. Unlike XIV, it dropped only 0.8% from 4/2 to 4/10. Most importantly, unlike most VIX products in the market (e.g. the Short Term Index, Mid Term Index and the S&P 500 Dynamic VIX Futures Index), it has a low correlation to both S&P 500 and the VIX spot.
Exhibit 1: Total Return History (click the image below to see it in full size)
Exhibit 2: Performance Statistics