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Monday, March 26, 2012

Hidden cost of XIV

Two popular options to trade short-term volatility are VXX an XIV ETNs. By their design, they should provide exactly the same daily returns, but with opposite sides. Both should have similar yearly fee. However, I have noticed that XIV shows a consistent underperformance relative to VXX. Time for a quantitative investigation.
Imagine we would trade a portfolio of long VXX, long XIV and both legs having the same capital, rebalancing at the close. In this case, the daily returns of VXX an XIV should cancel each other out, and cumulative pnl should be flat. But in reality, a long volatility position using short VXX outperforms a long XIV by about 7% a year. Correcting for borrowing cost of VXX, which is about 2.5% , there is still about 5% difference!.
The green line represents the path that a long XIV+VXX portfolio have followed since its inception. To make a realistic estimation of the daily relative loss, I have first filtered out the outliers. The red line shows an estimate of the daily cost of XIV relative to VXX.
Conclusion: playing short volatility using XIV will cost you  about -0.028 % per day, relative to a short VXX position (borrow cost not included).

P.S I'm not sure there is money to make by shorting both ETNs, daily rebalancing cost will most probably eat away all potential profits.

Update 22/07/2012: here is a chart of an estimated price of XIV by taking a direct daily reverse of VXX. All prices are normalized (starting at 100).