VIXY (VIXY): Possible Short-Term Gain, Likely Long-Term Pain

The stock market continues to bounce off the walls, reacting to the laundry list of developments that have been impacting the economy lately:

1. record-high inflation;
2. rising interest rates;
3. signs of a global economic slowdown;
4. disrupted supply chains;
5. COVID-19 flare-ups around the world;
6. the war in Ukraine, and so on.

Given all the uncertainty in 2022, it is not a surprise that the ProShares VIX Short-Term Futures ETF (BATS:VIXY), a fund that has long exposure to the fear index, has been performing so well relative to the S&P 500 (SPY) (see chart below).

All the factors listed above seem far from reaching a point of resolution. For example, the increase in consumer prices have yet to moderate, although it could soon. Also, the Federal Reserve has only started to raise short-term interest, and it is anyone’s guess how far the central bank may push with monetary tightening.

Given the context, owning some VIXY for the sake of protecting the portfolio against sizable losses could make sense — I have even explained how to use a blend of SPY and VIXY to produce superior risk-adjusted returns over time.

But beyond the short term, when VIXY can very well trend (as it often does) and produce additional gains in 2022, the case for owning the ETF for the longer haul is starting to lose appeal. Below, I explain why.

A word on VIXY

As usual, I like to set the stage by reviewing the basics of the ETF under review. ProShares VIX Short-Term Futures is a fund that owns cash only, but that also holds a long position in short-term VIX futures.

Currently, VIXY is long the May 2022 (55% notional exposure) and the June 2022 (45% notional exposure) contracts. Every 30 days or so, the ETF exits the front-end derivative and rolls the position forward by a month.

VIXY has about $400 million of assets under management. It trades very frequently: about $200 million worth of shares each day, on average. The management fee is 85 basis points, which I would call fair among ETFs that follow a more esoteric, derivatives-based approach.

Likely to be a loser

A quick look at historical price behavior below suggests that VIXY is not a fund to own lavishly and hold over very long periods of time. The ETF has lost 90% of its market value over the past five years and 99% in the last decade. This is the case primarily because of what is known as “negative roll yield”: VIXY is designed to consistently buy high and sell low when the VIX term structure is in contango, which is usually the case.

But there is more. As I explained in previous articles, the fear index has two important properties: (1) while it often trends in the short term due to what is known as volatility clustering, (2) it tends to revert to the mean in the longer term. The latter is a crucial point to understand before committing money to VIXY at today’s levels.

The best time to buy into a VIX fund is when one is not needed — not unlike a homeowner’s insurance policy, which should be bought before, not after, the house catches fire. This is why, in November 2021, I argued that VIXY had become “compelling once again”.

The opposite is true today. The VIX reached 36 intraday on May 2, the peak since March 2022 and one of the highest readings since late 2020. For perspective, the fear index has averaged 19.5 since 1990 and 25.1 since mid-February 2020, when the S&P 500 reached its pre-pandemic highs. Meanwhile, the S&P 500 solidified its position in correction land: the index is currently 13% away from its early January 2022 all-time high.

When equities are discounted relative to a prior peak and the VIX hovers well above its average, investors are better off leaning towards the former and staying farther away from the latter. I ran the numbers to confirm the hypothesis.

Since 1990, the VIX index has “returned” (I should be careful with the wording here, since one cannot invest in and earn returns in the VIX) an average of 1.6% per year. However, take note of a few one-year forward metrics on the performance of the VIX whenever the S&P 500 was in a correction (e.g., today) vs. when stocks were hovering near peaks:

• Average: the VIX declined -11% per year on average when the S&P 500 was in correction vs. climbed +16% when the S&P 500 was near a peak;
• 75th Percentile: at the higher end of the spectrum, the VIX has climbed +6% per year when the S&P 500 was in correction vs. +32% when the S&P 500 was near a peak;
• 25th Percentile: at the lower end of the spectrum, the VIX has declined -38% per year when the S&P 500 was in correction vs. -15% when the S&P 500 was near a peak.

The key takeaway

I do not believe that the case for holding VIXY today, when the house (i.e., equities market) is already partially on fire, is a strong one. Set aside the negative roll yield, which alone is a reason to be very careful with a VIX fund like this: the timing is probably not ideal for an investment in the ETF, as the fear index is likely to revert lower in the next few months.

To be fair, I still own some VIXY shares in my portfolio. But I keep only minimal amounts of it to balance some leveraged equity positions that I continue to hold. As a conviction play, I would probably not consider buying the ETF at current levels.