An Alternative Passive Investment Strategy
Keeping with my theme from my last post, I’ll look at a common passive investment strategy, a 50/50% investment in SPY (S&P 500) and IEF (10-year UST), and replace the equity exposure with a (volatility-equivalent) investment in the volatility ETF XIV.
First our baseline, a 50/50% investment in SPY/IEF rebalanced monthly (frictionless):
Our alternative strategy is as follows:
When front month VIX futures will close below the second month (contango), go long at the close X% XIV + 50% IEF.
XIV is of course (much) more volatile than SPY, so to compensate, only buy the amount of XIV that is the volatility-equivalent of a 50% SPY position (based on the standard deviation of daily SPY and XIV returns over the previous 63-days).
Today, for example, that would be about 9% XIV, 50% IEF, and the remainder in cash.
When front month VIX futures will close above the second month (backwardation), go long at the close 50% SPY + 50% IEF (i.e. the original passive strategy).
Rebalance positions at the end of each month.
And the results, the baseline in grey and the alternative strategy in red (frictionless):
Numbers for the number lovers…
These two strategies are well correlated and very similar in terms of volatility and beta exposure.
The extra juice on the alternative strategy is mostly from the positive impact of the term-structure when futures are contangoed.
This alternative strategy isn’t without its own unique risks.
Some immediate ones that come to mind are (a) losses in volatility ETFs can accelerate very quickly during market crashes, and (b) should the VIX futures term-structure flatten or grow unstable (i.e. if today doesn’t predict tomorrow), the trade breaks down.
Remember, these are still relatively new products and we should be cautious about putting too much faith in a limited past to project the future.
P.S. a tangentially-related topic is the limited upside remaining in Treasuries (which I ranted about here, here, here, and here). That is of course going to be a drag on the strategies presented here, and yet another reason to be thinking about boosting returns even for simple passive portfolios like this one.
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Filed under: Trading Strategies, VIX & Volatility | 20 Comments