What is XIV and How Does it Work?

XIV is the VelocityShares Daily Inverse VIX Short-Term ETN, which provides investors exposure to short VIX futures contracts. Put simply, investors who buy XIV are short S&P 500 volatility futures.

How Does XIV Work?

While daily fluctuations in XIV are caused by buyers and sellers of the shares, the performance is tied to the inverse of the daily returns of the S&P 500 VIX Short-Term Futures Index, which tracks a portfolio of first- and second-month VIX futures contracts with a weighted-average time to maturity of 30 days (consistent with the VIX Index methodology).

For example, if the VIX Short-Term Futures Index rises 5% in one trading day, XIV should fall by 5%. Conversely, if the VIX Short-Term Futures Index falls by 2.5% in one trading day, XIV should increase 2.5%.

How closely does XIV track the returns of the VIX Short-Term Futures Index?

The chart below shows the daily percentage returns of XIV and the S&P 500 Short-Term VIX Futures Index from January 4th, 2017 to February 13th, 2017:

XIV Returns vs. S&P 500 Short-Term VIX Futures Index (SPVIXSTR)

Data Sources: Yahoo! Finance & Investing.com

Clearly, the daily returns of XIV are inversely related to the returns of the VIX Short-Term Futures Index (which tracks the near-term VIX futures contracts). Any discrepancies you see can be attributed to the fact that XIV closes at 4:00 P.M. E.T., while VIX futures close at 4:15 P.M E.T. So, if the VIX futures experience notable changes in the 15 minutes after XIV closes, the returns of XIV on the following trading day will be different than the index. 

At this point, you may be wondering: if the fluctuations in XIV are driven by buyers and sellers in the marketplace, won't its returns stray from the returns of the VIX Short-Term Futures Index? If the value of XIV differs too much from its "Indicative Value," there are entities known as Authorized Participants that have exclusive rights from the ETN issuer (Credit Suisse, in this case) to intervene in the open market to bring the ETN back in line with its Indicative Value (you can track this intraday with the ticker symbol XIV.IV).

Now that you know the basics of what XIV represents, let's take a look at how XIV may perform when the VIX term structure is in contango and backwardation.

XIV Performance: VIX Futures in Contango

When the VIX futures are in contango, VIX futures contracts trade at a premium to the VIX Index, and longer-term VIX futures contracts trade at a premium to near-term VIX futures contracts (resulting in an upward-sloping curve when the price of each contract is plotted). Now, as time passes, each VIX futures contract will converge towards the VIX Index. So, when contango is present, VIX futures contracts steadily lose value as they are "pulled" closer to the VIX Index.

Since XIV's performance is inversely related to the returns of the near-term VIX futures, the gradual decrease in VIX futures contracts translates to steady increases in XIV. Let's take a look at a visualization of this concept:

XIV Contango Profits

Data Sources: Yahoo! Finance & CBOE VX Futures Data

As we can see, the near-term VIX futures contracts are trading at a premium to the VIX Index. Since the VIX Index remains low during this period, the near-term volatility futures steadily lose value as they converge towards the VIX Index. Since XIV's performance is inversely related to the performance of the near-term volatility futures, XIV appreciates when the volatility futures fall.

During prolonged periods of low market volatility, XIV tends to rise substantially, as the constant bleed of the near-term VIX futures creates a positive drift for XIV.

So, if market volatility is low and you believe it will remain low, XIV can make for a good investment. However, it's important to understand what can go wrong, which we'll discuss in the next section.

XIV Performance: VIX Futures in Backwardation

The VIX Index is not always below the near-term VIX futures. When volatility rises substantially, the near-term volatility futures typically trade at a discount to the VIX Index. The result? If the VIX remains elevated, the near-term volatility futures will appreciate as they converge towards the VIX. The price appreciation of the VIX futures translates to losses for XIV. 

Let's take a look at a period in which XIV suffered from the upward price pressure in near-term VIX futures:

VXX Backwardation Gains

Data Sources: Yahoo! Finance & CBOE VX Futures Data

In this scenario, we can see that the near-term VIX futures (October and November contracts) increased steadily, causing XIV to drift lower. In early October, the VIX Index quickly increased from 15 to 25, "pulling" the VIX futures up with it. As a result, XIV plunged to $27.5 from its price of $40 at the beginning of the volatility increase. 

So, in periods of high market volatility, XIV becomes a much riskier investment, as it will lose value when the VIX futures increase as they're pulled towards the VIX (assuming the VIX remains elevated).

Now that you know how XIV performs during periods of rising and falling volatility, let's examine how often the VIX futures are in contango and backwardation.

How Often Have VIX Futures Been in Contango?

To quantify contango and backwardation in a simple manner, we'll plot the difference between the front-month VIX future and the VIX Index from 2008 to present:

VIX Futures Contango/Backwardation History

Data Source: CBOE VX Futures Data

Positive values indicate that the nearest-term VIX future is trading at a premium to the VIX Index (contango). Conversely, negative values indicate that the VIX Index is above the nearest-term VIX future (backwardation). Clearly, the VIX term structure is rarely in backwardation. Knowing this, how has XIV performed since its inception date?

XIV Since Inception

Since XIV's inception date in late 2010, the product has risen approximately 640%. However, the strong long-term performance hasn't been without its fair share of violent drawdowns. Since XIV's performance is based on daily percentage changes in the near-term VIX futures, a significant one-day volatility increase can lead to disastrous returns in XIV. For example, if the VIX Short-Term Futures Index rises 30% in a single day, XIV will lose 30%. If XIV is initially trading at $50, it's price is expected to be $35 after the 30% volatility increase.

So, while XIV's "normal" trajectory is upward-sloping, the drawdowns are substantial when market volatility surges, as it does from time to time.

Lastly, XIV charges an investor fee of 1.35% per year. The fee comes out of XIV on a daily basis.

Summary of Main Concepts

To quickly summarize what this post has covered, here are the key points to remember:

While products like VXX track the performance of the near-term volatility futures, inverse-volatility products like XIV track the inverse of the daily changes in the near-term VIX futures (the S&P 500 VIX Short-Term Futures Index).

XIV tracks the inverse of the daily returns of the S&P 500 VIX Short-Term Futures Index, which tracks the two nearest-term VIX futures contracts with a weighted average time to maturity of 30-days.

A majority of the time, the VIX term structure is in contango, which results in falling VIX futures prices as they converge towards the VIX, translating to steady price increases in XIV.

When the VIX term structure is in backwardation, XIV will lose value if the VIX remains elevated, as near-term VIX futures appreciate in value as they converge towards the VIX.

While buying and holding XIV has historically been a frequent winner, the infrequent losses can be substantial (just like any other short volatility strategy). So, be sure to approach XIV with a pre-defined strategy.

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