January 31, 2018
A few of us here at BCK recently flew up to Canada for vacation this winter. If any of our subscribers are snowboarding or skiing fanatics, we highly recommend taking a trip to Whistler. The scenery is great and there are an endless number of ski runs. Being the sensible and rather frugal investors we are, we chose to fly into Seattle (significantly cheaper flights than to Vancouver) and then drove through the border crossings up into Canada.
As we drove through the rolling hills of south British Columbia and drove onward towards the Rockies, we couldn't help but make a comparison between the landscape and the markets.
The Rolling Hills: The easy drive, once we had made our way through the long lines at the customs gate near the border, reminded us that 2017 was a relatively 'easy' year for nearly all investors. XIV returned 187.57% (closing data) in 2017, with SPY returning 21.69%. An incredible year for volatility investors, and even more so for the buy and hold folks out there. Unfortunately, the fact of the matter is that 2017 was an easy year to capture returns for volatility investors; buy and hold XIV strategies have outperformed many of the algorithms and strategies employed by many in our volatility community, including ours; however, we must note that 2017 was very much an anomaly for VIX traders. Our anomaly begins with the average closing price level for VIX each year which is shown below.
The average VIX was 11.09 in 2017, the lowest year on record since 2008. 2017 has been labeled "the year of low volatility" by many volatility experts and rightly so. This low volatility has been a contributing factor for XIV's massive returns in 2017; VIX futures were rolling down to spot nearly every month, which, in turn, meant XIV was increasing in value much of the year.
Over its lifetime, the VIX has established an average level of 16-18. Note in the chart above that VIX barely reached the 16 level twice in 2017. Also note that after these spikes, volatility subsided back to historically low levels.
Low volatility environments are often deemed dangerous environments for XIV investors because a consistently low VIX can be a signal for investor complacency. This can mean that things are going well for the market and that economic policies that are being laid in the future are easily predicted by the market and have been priced in. An unexpected change, however, could send XIV tumbling. Of course, investors are more likely to be scared from an unexpected event than a planned event like a typical Fed rate hike. A particular situation in which this occurred took place from August 7th to August 11th, when XIV experienced a near 28% drop in just a few days. Our benchmark, SPY, only experienced a drawdown of 1.5%.
The Canadian Rockies: This type of drawdown is what we want to highlight with this post. Investing in volatility products likely will not be the smoothest of rides. This, of course, does not mean it will be unenjoyable.
Our drive through Vancouver and up into the mountainous regions of Canada reflected the landscape one should anticipate encountering when trading volatility products. XIV investors should expect their investment landscape to reflect that of the Rockies: steep inclines, leading to higher and higher peaks, but also with steep drop-offs leading down into the valleys.
Historically, XIV has had a beta of around 4. This means that if the market gains 1% we should expect XIV to gain roughly 4%. This also means that a 1% drawdown for SPY would lead to roughly a 4% drawdown for XIV. Volatility products are inherently more volatile than market benchmarks. Investors are taking on more risk with volatility products, but are rewarded with higher returns, as we have clearly seen with XIV's performance this past year.
Volatility investments are not for everybody. It is important to consider one's risk tolerance before committing to an investment strategy. If you are the type of investor who panics at a 5% drop in their portfolio, then it is likely you will not enjoy the ride and should stick to 'safer' investment practices.
We encourage our readers to continue learning about volatility and to read through our blog for more relevant information. Conquer the hills before you move to the steep and treacherous mountains. Please email any questions you may have to bckvolatility@yahoo.com.