Over the last year, shares of the VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV) have increased by a solid 26%, continuing a several-year run of strong returns for the strategy. In this article, I will make the case that I believe there is continued upside for the ETN based on its underlying methodology as well as a forecast for suppressed VIX levels for the immediate future.
Understanding the Instrument
If you haven’t spent much time exploring the volatility ETP space, then ZIV is an instrument which likely isn’t on your radar. The reason why ZIV is a bit of an outlier in the volatility instruments offered is that it gives an inverse exposure to one of the lesser-known volatility indices, the S&P 500 VIX Mid-Term Futures Index. The most popular volatility index (as measured by market cap of ETPs following the strategies) is S&P Global’s Short-Term VIX Futures Index. This index provides direct exposure into the front-two months of S&P 500 VIX futures provided by CBOE. The Short-Term Futures index is notorious for roll yield in that over the last decade, it has destroyed wealth at an annualized rate of -53% per year.
The general idea behind the Mid-Term VIX Futures index is that by shifting exposure further back in the curve, roll yield can play less of a role in the overall returns of the strategy. Specifically, the strategy which ZIV follows holds exposure in the fourth through seventh month VIX futures contracts, stepping much further down the curve than the short-term strategy. The tangible effects of the diminished impact of roll upon the index mean that the annualized loss is roughly half of what is offered by the shorter-term index as seen in the following chart provided by S&P Global:
Roll yield may sound complex, but it’s actually fairly simple. There is a general tendency of financial markets for prices in the later months of a forward curve to trade towards the front of the curve as time progresses. This tendency results in a gain or loss over time depending on the months held by a strategy as well as the structure of the market. At present, the VIX futures market is strongly in contango:
The underlying index which ZIV gives the inverse return for is currently holding exposure in the back months of the curve. These months are priced higher than the front of the curve which means that through time, the prices of the contracts held will tend to trade down in value towards the front month contract resulting in a loss from roll yield. ZIV offers an inverse return of this index meaning that for long traders in the instrument, roll yield is currently a strong positive and upside is more likely than downside in the shares.
The VIX Markets
In and of itself, roll yield is a strong reason to buy ZIV. The underlying index which ZIV offers an inverse return to has delivered a negative 24% annualized return for the past decade. This underlying upside relationship remains in place and shares in ZIV are likely to continue appreciating going forward due to the almost constant state of contango in VIX futures (data here).
This said, the market is giving very specific indicators which suggest that volatility will decrease going forward. Before jumping into these reasons, one of the first things to understand is that VIX and the S&P 500 are inversely correlated. As the S&P 500 rallies, VIX falls:
This means that if we can gain a directional edge in the market, we can largely make a call on the VIX itself. If we believe the S&P 500 is headed higher, then the VIX is likely headed lower.
From a technical perspective, I believe that we are in for further upside in the S&P 500.
As you can see in the above chart, momentum is poised to switch into positive territory as measured by the MACD. This indicator offers exceptional opportunities to grab slices of market action while limiting exposure to the downside. As you can see in the past, the last 5 crossovers into upside momentum territory resulted in gains over the next week to month on all but one occasion. In other words, given that we are almost certainly going to see a cross into positive momentum on the indicator, recent history would suggest that we are likely to see additional upside in the S&P 500 as a result.
The reason why this is significant for VIX traders is two-fold. First off, there is a direct inverse correlation between volatility and the changes in the S&P 500: as the S&P 500 rallies, the VIX is likely to fall further. However, there’s also a quantified statistical edge present in selling the VIX when we hit fresh highs in the S&P 500. As you can see in the following chart (which uses market data since 1992), when the S&P 500 hits a fresh 20-day high, the level of volatility seen in the market drops over the next month roughly 55-60% of the time.
At present, we are not at a fresh 20-day high in the market which means that these statistics apply to a situation which has not yet occurred. I believe that the momentum indicator suggests that we will see further upside which will propel us into a fresh 1-month high as evidenced by the magnitude and duration of recent momentum moves. As the market rallies towards these fresh highs, the VIX will fall in conjunction with the rally. When the market hits these fresh highs, statistics would suggest that the decline in VIX will continue. In other words, trading the inverse volatility trade at this time is likely a strong play. It’s time to buy ZIV.
ZIV offers an inverse exposure to an index which has declined by 24% per year for the last decade due to roll yield. The market is poised for fresh upside momentum which will likely see the VIX fall in tandem. When the market hits a fresh high, we will likely see further downside in the VIX.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.