Why I love leveraged ETFs/ETNs…particularly UVXY

In a phrase: vol drag.

Volatility drag (‘vol drag’) is a product of compounding a return series which is multiplied by a constant.  In the case of UVXY, the return series is the movement in the VIX index, which is in turn a measure of S&P 500 30-day implied volatility.  The ETN aims to provide 200% of the daily change in the VIX index.

The immediate appeal of the product seems easy, at first glance: the VIX tends to move in opposite direction to the S&P, so why not buy VIX to hedge an equity portfolio.  While I’m at it, why not cut my hedging costs by buying a 2x version of the VIX?  Well, that’s where vol drag comes into play.

It’s important to mention that UVXY was, apparently, never created for investors holding more than 1 day.  Why?  Well, the first thing to mention is the VIX, like almost all underlyings, moves up and down: there is no smooth path for the VIX:

Screen Shot 2014-08-27 at 10.41.31

In fact, the VIX moves a lot: realised volatility for the VIX is around 125% these days, or around 8-10x the volatility of the S&P.  When we multiply that return series by 2, we increase the daily volatility by the same factor.  When we compound those returns daily, to make the price series for UVXY, we find a significant drag.  The difference between arithmetic returns (e.g. the 2x daily return achieved by UVXY) and geometric returns (e.g. the UVXY price series, which is a daily-compounded return series) is equivalent to 50% of the variance of the underlying (VIX), which is a big number.  See here for more explanation.

There’s another reason I love UVXY, which is persistent futures contango.  Because the VIX is not directly investable, UVXY invests in a combination of front & 2nd month VIX futures to achieve its objective.  The persistent contango is, ironically, likely a result of so many folks buying VIX ETFs/ETNs – more equity hedgers than speculators.  Anyway, because later-dated futures contracts cost more than nearer-dated, or indeed cash VIX, UVXY (and other VIX ETNs) have a persistent negative drag from the contango.

How does it all add up?  Here is YTD for UVXY versus its underlying, the VIX index.  A reminder: the objective of the ETN is to provide 200% of the daily return of the VIX; the persistent decay of UVXY is due to the factors explained above (in addition to a third, small, factor: a 0.75% annual management fee):

Screen Shot 2014-08-27 at 10.58.23

So, what to do with this?  The main risk to mention with UVXY is massive skew and kurtosis: that is, the very real risk for a large upward move when the VIX spikes.  So while I look at a picture like the above and say ‘Go short!’, I think back to times like 2011 where UVXY explodes both because of a spike in VIX, and because of a swift change in futures contango:

Screen Shot 2014-08-27 at 11.02.22

Yes, UVXY can blow up.  So, the answer is a combination of going short UVXY with buying upside protection.  If the protection can be bought reasonably (it usually can), and the investor can stomach the big jumps (knowing max loss from inception is helpful here), it seems a good trade.  Extra credit: wait for a VIX spike before opening a trade.  

(Source for charts was Google Finance)


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