Nature of short VIX strategies

Question

By now, we all pretty much know that the recent upsurge in the VIX Index caused the spectacular failure of some Exchange-Traded Products (ETPs) or Exchange-Traded Notes (ETNs) written on it. An example from The Financial Times, where you can see the short index collapsed to $0$:

On the other hand, looking at the VIX evolution over the last year, we barely observe any significant price movement that might explain the exceptional performance of these products. From the CBOE webpage:

From what I have read, I have the impression these short VIX strategies are basically leveraged short positions of forwards/futures on the VIX Index, thus they are carry-positive strategies: all things remaining equal from strategy inception to strategy maturity, the holder of a short position in the strategy will be cashing-in the "convenience yield" $-$ whatever the convenience yield corresponds to in the context of the VIX, which is a non-traded asset.

In the light of the charts above, I ask myself the following question: is there anything else to these short VIX strategies other than convenience yield capture based on the hope that the index will remained subdued? Has anybody an understanding/experience with these products?

Answer 1

You are right. There are a number of variations around that theme, but the ones that blew up are essentially shorting short-dated volatility via the VIX futures, with some frequent rebalancing mechanism between typically the front two futures, that ensures the portfolio’s maturity and notional exposure remains more or less constant.

The latter is in itself problematic in particular because a constant notional short exposure requires buying after a rally and selling after a sell-off (in the underlying reference asset, here the VIX futures) thus ensuring a slow grind towards zero anyway due to volatility drag. This last point in particular was in the small prints of the XIV which one can assume was seen by its sponsor bank as insurance against future investor complaints (time will tell if that’s right but I’m not holding my breath).

Answer 2

In my opinion, holding these ETFs long-term is just a gamble that plays like a continuous double-or-nothing betting game (it's not exactly that, but has similar characteristics). It's not the same as a short-volatility strategy, and it's because of the nature of the product.

I would first take a look at this paper from Blackrock: VIX your portfolio. This paper will provide some insight into where your profits are coming from in selling volatility. There are many examples on this site showing that the price implied by these futures or options are historically overpriced.

To get a better feel, I'd like to use a different daily exposure product other than volatility because there's some animosity towards these volatility products (more so now). As an example, take United States Oil Fund LP (ETF) - USO, the oil ETF. This has measurable deviation over longer-dated periods from holding the front-month future. In my opinion, the ETF is doing what it's supposed to do (and does it very well) which is provide daily exposure to the price of these oil futures.

The vol products are also providing this daily short vol exposure. If you hold this for several years, like the FT article shows, you are continuously re-investing your profits for the next sessions short vol trade, which I believe is a massive gamble.

To test something out for yourself, look at another inverse product - and it doesn't have to be leveraged - and see how well it replicates exposure over any period other than daily to actually shorting the underlier. But on a daily basis, they're some of the most efficient market vehicles available, especially to those with sizing needs or account restrictions.

There'a a case to be made that some of these products didn't fail, but did exactly what they were supposed to do.