XIV: Sorry To Tell You So, But I Told You So

Credit Suisse announced this week that it will end trading in its VelocityShares Daily Inverse VIX Short-Term ETN (XIV) on February 20. Consequently, as the ETF has lost 95% in the last five trading sessions, its holders will not have the chance to retrieve their devastating losses. Despite the exceptional performance of XIV until recently, I had warned investors of its excessive risk in two articles. In this article, I will analyze why so many investors incurred this disaster and will advise investors how to avoid similar disasters in the future.

First of all, XIV aims to replicate the inverse of the daily performance of the S&P 500 VIX futures. Therefore, as the market has enjoyed an exceptional nine-year bull market, the volatility index – VIX – has remained suppressed and XIV has thrived. Even better, during calm periods of the market, VIX is in a contango structure, i.e., its distant futures are more expensive than its prompt futures. Therefore, as XIV rolls from the prompt future to the next month’s future every month, it benefits from this difference every month. In calm periods, the difference between the two contracts has hovered around 5% so it is not hard to understand why XIV has offered exceptional returns during the ongoing bull market. More precisely, until last week, the ETF had dramatically outperformed S&P since its inception in late 2010, as it had enjoyed a 1200% rally whereas S&P had only doubled during this period.

The ETF began trading after the Great Recession and hence it was not tested under stress conditions. Nevertheless, it offered some serious warning signals in two occasions, which were however ignored by most investors. More specifically, in the summer of 2011, when the US was downgraded by credit rating firm S&P, the market plunged 16% in a matter of three weeks. During that period, XIV plunged 71%, from 19 to 5.5. When an ETF loses 71% in three weeks amid a mere market correction, investors should realize its excessive inherent risk. However, XIV retrieved its losses in less than two years and thus most investors did not take their lesson from that incident.

Another occasion was the second half of 2015, when China devalued its currency and thus caused great anxiety in the market. While S&P lost 13% in that instance, XIV collapsed once again and lost 65%. However, it retrieved its losses in one and a half years. Even better, it managed to triple in value since then compared to its pre-slump level. As a result, its collapse passed under the radar of most investors once again. The reason for its collapses amid spikes in volatility is the fact that the ETF aims to track the inverse daily (emphasis: daily) performance of VIX. Consequently, the ETF increases its positions when it appreciates and reduces them when it falls. In other words, it is forced to buy high and sell low when VIX wildly oscillates. This negative bias causes excessive losses when the market is volatile.

It is also remarkable that Credit Suisse, the issuer of XIV, clearly warned investors that the ETF could go to zero on a single day with extreme volatility. According to its description, the ETF was designed to achieve its stated investment objective on a daily basis and hence its performance over longer periods of time could differ significantly from its stated daily objective. Consequently, investors were advised to avoid buying the ETF with a long-term horizon. Instead they could use it on a short-term basis, only as an additional investing instrument. Unfortunately, it is likely that most ETF holders did not pay attention to this description and eventually incurred excessive losses.

The lesson from this case is that investors should carefully study the analytical description of an ETF before purchasing it, no matter how attractive its historical performance is. While this may seem obvious, very few investors actually implement it. Moreover, investors should carefully examine the price behavior of the ETF during stress periods in order to conclude whether they can handle its risk. A market sell-off will inevitably show up sooner or later and hence investors should certainly know what to expect from their holdings. Otherwise, they are likely to face extremely negative surprises, such as the liquidation of XIV on a day that the S&P lost just 4%.

To conclude, when I first learned about the way XIV benefited from the contango structure of VIX, I was really attracted to the ETF. Then I check out its performance and I was even more amazed. Fortunately, I read the analytical description of the ETF before purchasing it and thus saved myself from the subsequent disaster. As ETFs have a wide range of objectives, investors should certainly make sure they understand them thoroughly before purchasing them. Moreover, they should examine how the ETFs perform during stress periods. Only in this way will they avoid investing disasters, which may completely derail their portfolio.