This blog post continues a series exploring volatility-linked exchange-traded products.
In my previous blog post, I discussed how volatility-linked ETPs are likely to lead to significant, if not catastrophic, losses if they are used in a buy-and-hold strategy.
In this post, I want to explain the mechanics of how this process works.
Most volatility-linked ETPs must, by prospectus, maintain a constant maturity. For instance, the VXX pricing supplement states:
(The VXX) is linked to the performance of the S&P 500 VIX Short-Term Futures Index TR that is calculated based on the strategy of continuously owning a rolling portfolio of one-month and two-month VIX futures to target a constant weighted average futures maturity of 1 month.
In order to keep the weighted average futures maturity of one month, the two contracts will have to be adjusted on a daily basis. This necessarily implies buying more of the two-month VIX futures and selling the one-month VIX futures.
Having to keep buying longer dated futures and selling shorter dated futures is what creates losses over time.
Contango is a term describing the typical futures market curve where longer dated contracts are more expensive than shorter dated contracts, all else being equal. (The opposite of this is known as “backwardation”, and is rare.)
The VXX pricing supplement describes contango as follows:
… many of the contracts included in the Indices have historically traded in “contango” markets. Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months. VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to “roll” the futures. The existence of contango in the futures markets could result in negative “roll yields”, which could adversely affect the value of the Index underlying your ETNs and, accordingly, decrease the payment you receive at maturity or upon redemption. (Emphasis added)
Chart 1: VIX Futures Curve
Negative Roll Yield
In plain English, by continuously buying longer-term VIX contracts and selling shorter-term VIX contracts the VXX ETN is buying high and selling low every day. This phenomenon is known as “negative roll yield”.
It is a mathematical certainty that negative roll yield will erode the value of any investment that maintains a constant maturity such as the VXX. As discussed in my previous post, the longer volatility-linked ETPs are held, the longer their holders are subjected to negative roll yield.
This results in a death by a thousand cuts, one each day. The certainty of negative roll yield over time is why constant maturity volatility-linked ETPs all head towards zero. Due to Zeno’s paradox and the magic of reverse splits, they never reach zero. However, that is cold comfort for anyone who has lost 99.9 percent of their investment.
The supervisors of any firm allowing their advisors to trade in volatility-linked ETPs should be well versed in the mechanics of these products. Clients certainly don't understand these complex products and frequently their advisors do not either. Their suitability is limited to trading clients who want to speculate on intra-day or one-day changes in the VIX index, and they are unsuitable for a buy-and-hold strategy.
Furthermore, supervisory systems should flag any volatility-linked positions held more than a day.
 Barclays iPath S&P 500 VIX Short-Term Futures ETN pricing supplement; July 18, 2018; Available at: http://www.ipathetn.com/US/16/en/documentation.app?instrumentId=259118&documentId=6091544; Accessed October 25, 2017; PS-1.
 Id. at PS-13.
 VIX Volatility Curve; Bloomberg; Accessed October 25, 2017.For information about securities expert Jack Duval, click here.