February Correction: VIX and XIV

Markets in February saw the end of a 499-day (almost two years) winning streak, when the S&P 500 had avoided even a 5% pullback.   At the end of that period equity markets were climbing at a parabolic fashion, with gains quickening into January 26th top.   From December 26th to January 26th saw a gain of 7.2%, or an annualized pace of 132%, capping a two-year gain of more than 55% for the S&P500.

The current correction, has given back almost 12%.   The cause has widely been attributed to a climb in interest rates and finally a larger than expected print in Average Hourly Earnings.  While this data point coincided with the turn, rates had been climbing since early September and accelerated along with stocks in January.  There were a few weeks where rapidly climbing rates occurred at the same time as rapidly climbing stock prices, and then when prices fell, the fall was attributed to those same rising rates.

Todays Wall Street Journal finally had a decent article on another cause of the rapid decline in stock prices.   Over the past few years, “selling volatility” via a few inverse-VIX etp’s had been a huge winner. The largest vehicle, ticker XIV, had gone from $20/share in early 2016 to $146/share in January 2018.  This ETP’s price would go up an equal amount, in percentage terms that the VIX (aka ‘fear index’) would decline. As long as volatility stayed low, XIV’s price would climb.

There were two big problems with this product.  As it grew to several billion in assets, it became so large that that it dwarfed the underlying derivatives market in which it participated.  If the VIX moved a little more than it had in recent weeks, it would cause the fund to overwhelm the derivatives market.   In early February the fund owned 42% of all the outstanding March VIX futures contracts.  Any disturbance in the VIX could require the fund to purchase more than half of all the contracts, that it had originally sold in a very short period of time.

The second problem was that its returns were 100% of the opposite of whatever the VIX did in one day.  That means if the VIX moved from 10 to 20, a gain of 100%, then XIV should lose 100% of its value.  The kicker is that this indeed has happened a few times over the past 10 years.

So the set up was a parabolic price advance, and then a concern that maybe rates were going up too fast, which may push central banks to tighten monetary policy more quickly, which caused the VIX to rise from all time lows, forcing XIV to overwhelm the underlying markets, creating a vicious circle of selling that spilled over into equity futures, exacerbating the stock market decline.  XIV stopped trading on February 21st, closing at $6.04.

Adam Waszkowski, CFA

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