VIX Strategies – Roll-Yield and Why You’re Thinking About it Wrong
This is a short post to clarify something we see get confused ALL the time – roll-yield.
First, let’s define a few things
1) XIV – Velocity Shares Daily Inverse VIX short-term ETN
XIV is an ETN (exchange-traded-note) that attempts to track the inverse of the daily performance of short-term volatility. The way XIV works is that it sells (XIV is short volatility) positions in the front two VIX future contracts, such that the weighted average of the days to expiration equals 30 days. For example, if there are 50 days to expiration for the second month VIX future, and 22 days to expiration for the front month VIX future, XIV would be waited 29% second month, 71% front month. Essentially, XIV attempts to replicate a short 30-day VIX future position (we’ll refer to this as a “synthetic 30-day future”). Further, each day, XIV resets the weightings of the front two futures so that the weighted average always equals 30-days. Historically, XIV has produced exceptional returns (see the below chart), albeit with extreme drawdowns from time to time. People often point to roll-yield (but think about roll-yield incorrectly) to explain the exceptional historical returns in XIV – more on this below.
2) Contango and Backwardation
There are slightly different definitions of contango, depending on who you ask, but for our purposes, contango means that the VIX futures curve is upward sloping. The opposite of contango is backwardation. You can have parts of the curve be in contango and other parts be in backwardation. The important thing is, the VIX futures curve is typically in contango.
Contango and Backwardation
The front part of the curve is in backwardation, while the backend of the curve is in contango. Chart from vixcentral.com
Contango
The entire curve is in contango. Chart from vixcentral.com
Ok, now that we have a few definitions out of the way, let’s discuss the confusion behind roll-yield.
Roll-Yield
Because the VIX futures curve is normally in contango (upward sloping), and XIV is constantly buying front month VIX futures (priced lower than second month when in contango) and selling second month VIX futures (priced higher than front month when in contango) to rebalance to a 30-day weighted average, you hear people say that XIV is constantly “buying low, selling high”. People often refer this “buying low, selling high” dynamic as “roll-yield”, and use this to explain the exceptional historical returns in XIV. First, referring to the selling of second month VIX futures to buy front month VIX futures as “roll-yield” is simply incorrect. Second, this “buying low, selling high” action of XIV (when the VIX futures are in contango) has NO impact on the price of XIV. We’ll come back to what roll-yield really means. First, let’s tackle the “buying low, selling high” idea.
Let’s assume you have a two stock portfolio worth $100k. Stock ABC trades for $10, and stock XYZ trades for $100. You start off with a 50/50 weighting between the two stocks. Your portfolio looks like the following:
Now, let’s say for whatever reason you want to decrease your allocation to stock XYZ to 40% and increase your allocation to stock ABC to 60% (the actual percentage allocations are not important, they’re just for demonstration) – in other words, you want to sell the higher priced stock and buy the lower priced stock, just as XIV “buys low, sells high” the front two VIX futures. Here’s what your new portfolio would look like:
Has your portfolio value changed because you sold the higher priced stock and bought the lower priced stock? Of course not! The number of shares owned for each stock changed, but the overall value of the portfolio remained constant. This is no different for XIV when it reallocates its weightings between the front two VIX futures, unlike what many people think.
So, what is roll-yield? What you have to keep in mind is that VIX futures get “pulled” closer and closer to spot VIX as they get closer and closer to expiration. This is because VIX futures settle into spot VIX at expiration – the VIX future and spot VIX must be equal at expiration. Further, each day that passes, the “synthetic 30-day VIX future” created by XIV becomes a 29-day future. In other words, each day that passes, XIV “rolls-down” the VIX future curve as it gets 1-day closer to expiration. Assuming volatility remains flat, when the VIX future curve is in contango (upward sloping), the “roll-down” from 30-days to 29-days creates a positive yield for XIV (remember, XIV is short a “synthetic 30-day future”, so XIV gains when the futures “roll-down” to a lower value as they get “pulled” one day closer to spot VIX). THIS is roll-yield – it has nothing to do with “buying low, selling high”.
We hope this helps clarify the confusion behind XIV and roll-yield.
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