By: Steve Smith
As stocks continue march to all-time highs, investors often struggle between the desire to secure profits with not wanting miss out on future gains. Today’s investing advice will offer a way to reconcile this conflict.
Options can help bridge that gap by using a stock replacement strategy in which one sells off shares and buys call options in their place. This reduces capital requirement and overall risk, while maintaining upside exposure.
In this article from Stuart, Barton makes an interesting case for using volatility, namely the VelocityShares Daily Inverse VIX ST ETN (XIV) as a vehicle for stock replacement.
The thinking behind this investing advice is that during a bull market, volatility will remained subdued and therefore a shorting a the VIX in some fashion will be profitable. And thanks to the XIV’s construction, this ETN can keep rising.
Indeed the chart shows the XIV has basically moved in lock-step higher with bull market over the past few years.
Below, Barton dives into why he thinks XIV is a valid stock replacement and backs it up with data.
Stock Replacement Strategies (SRS) attempt to replicate equity performance without directly investing in the stocks they seek to replace. A popular example of this is buying deep in-the-money call options (or 1.00 delta options) such that the price of the options will increase by $1 for every $1 increase in the underlying stock price. In-the-money options can in this way deliver the same type of exposure to a stock for a lower upfront cost than actually buying the underlying stocks, and can simultaneously reduce the risk exposure of a portfolio. Imagine a $20 strike call option on a $50 stock; if the stock were to fall to zero, the $20 strike option in the SRS would only stand to lose its premium (say $35), while a traditional long stock position would lose its entire $50 value.
But option buying is not the only way to gain equity type exposure while managing risk. Another less known strategy is to replace equity exposure in a portfolio with a smaller, Beta-adjusted exposure to a high Beta stock. For example, trading in the VelocityShares Daily Inverse VIX ST ETN (Ticker: XIV) has grown in popularity as it has considerably outperformed major US equity indexes in the present bull market. Presently XIV’s 5-year monthly Beta to the S&P 500 is 4.78, which given its significant outperformance, seems to make sense.
But lets look a little closer at the XIV vs. equity performance. In making a comparison I’ll use the S&P 500 Total Return Index (SPTR) rather than the S&P 500 Index (SPX) because over a 5-year period the value of the dividends from the SPX do make a meaningful difference to the investment’s performance. Over the last 5 years the SPTR has gained 93%, while over the same period the XIV has gained around 456% – a return very close to what the Beta to the SPX would suggest. So could an investor with $100 invested in the SPTR have done better with $21 (beta adjustment of 100/4.78) invested in XIV? Well, possibly.
One advantage of the XIV SRS would have been that only $21 rather than $100 would have been put at risk, and the investor’s maximum downside would therefore have been limited to $21 in the most extreme case. This is an important observation, because while it is easy in an extended bull market to forget, 21% drawdowns in the equity market are not that uncommon, and have actually happened 12 times since 1929. Limiting maximum drawdown could therefore be seen as a key advantage of this kind of strategy by some risk adverse investors.
S&P 500 Drawdown and return statistics 
But XIV’s headline return over the last five years only tells us part of the story. While XIV may have outperformed the SPTR by more than five-fold, XIV’s daily volatility may have proved difficult for some investors to stomach. Over the same period that the SPTR rose 93%, it suffered a maximum drawdown measured daily of just 13%, while over the same period, XIV suffered a more nerve-racking 67.8% drawdown.
But what if this drawdown could have been reduced? What if the advantages of limiting maximum drawdown to just 21% could have been enhanced by employing some sort of dynamic XIV strategy rather than simply buying and holding the ETN?
Numerous XIV strategies exist, and many can be found for sale online – providers like VIX Strategies and Volatility Trading Strategies being among the leaders. Many of these strategies are based on one or another interpretation of Tony Cooper’s seminal 2013 paper ‘Easy Volatility Investing’, and while I won’t go into the details of Cooper’s strategies, I do encourage everyone to read his paper and have included a link to it here. In that paper, Cooper points out four competing approaches that he argues might outperform a buy and hold XIV strategy – approaches he categorizes as ‘Momentum’, ‘Roll Yield’, ‘Volatility Risk Premium’, and ‘Hedged’. Indeed, many of these strategies would have outperformed XIV considerably, and some could even have been considered less risky than buying and holding XIV.
So what if a conservative version of Cooper’s strategies could be used as an SRS instead of XIV?Well, earlier this year, Invest In Vol launched the Balanced Volatility Strategy (BVS) that combined the returns of three unique volatility trading strategies to harness what Cooper defined as the Volatility Risk Premium (VRP), or in Cooper’s words ‘the premium that an investor in some asset pays to reduce exposure to the volatility of the future returns of that asset’.
Since its launch, the BVS has performed as one might expect for a conservative VRP, returning 10.95% after fees verses XIV’s 22.99%. But BVS’s relative underperformance verses XIV is eclipsed by its relative drawdown over the same period. Since inception BVS has suffered a maximum drawdown measured daily of just 3.21% (Sep 8), compared with a maximum drawdown in XIV over the same period of 25.47% (Aug 16). Given this ratio, one could have held an almost 8 times larger BVS position over the period to have experienced the same maximum drawdown as XIV.