XIV Implodes

XIV was the ticker symbol for an exchange traded note (ETN) designed to move inversely to the VIX index (a measure of volatility in the S&P 500 index) on a daily basis.  So if the VIX index were to go up 10% XIV would ideally go down 10%.  Or if the VIX index were to go down 10% XIV would ideally go up 10%.  This is a simplification, an exact description with numerous warning and caveats can be found in the lengthy prospectus.   One of the warnings (see page PS-16) was:

... The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment. 

Nevertheless with historically low volatility holding XIV would have worked well in 2016 and 2017.  At the end of 2015 XIV closed at 25.8, at the end of 2016 XIV closed at 46.75 and at the end 2017 XIV closed at 134.44.  So for 2016 XIV returned 81.2% and for 2017 XIV did even better returning 187.6%.  This didn't go unnoticed and despite the above warning XIV began to attract long term holders.  Some them thought they had found the road to riches and invested most or all of their available funds. 

Then in February 2018 volatility returned to the market.  On Friday February 2 XIV opened at 126.5.  After a bad Friday for the S&P 500 XIV opened Monday February 5 at 109.57.  After a worse Monday for the S&P 500 XIV opened Tuesday February 6 at 10.49 losing all the gains for 2016 and 2017 and more in one day.  These losses caused the ETN sponsor to terminate the fund eliminating even the theoretical possibility of regaining the lost ground over time.

This of course came as an unexpected and costly shock to those investors who had invested heavily in XIV.  It seems to me that they had basically made 2 serious and avoidable mistakes.

First the fact that XIV had done well in 2016 and 2017 was no guarantee that it would continue to do well.  There are thousands of securities trading in the US markets and an infinite number of strategies for buying and selling them.  So at any given time there are bound to be many securities and strategies that have done well recently out of pure luck.  Also the more popular a strategy becomes the harder it is for it to achieve extraordinary returns as its popularity will move prices against it.  If for example someone noticed that stock prices tended to be low at 10 AM and high at 11 AM and lots of people tried to buy at 10 AM and sell at 11 AM this would drive up prices at 10 AM and reduce them at 11 AM until any excess profits were eliminated.  For this reason no widely known strategy should be expected to reliably produce outsize returns.  I should note here that this argument doesn't apply to index funds because they are trying for average returns not outsize returns.

Second if you have a strategy that has positive expected return but will occasionally suffer substantial losses it is unwise to invest all your money in it as it is very difficult to recover from losing most (or worse all) of your money.  If you lose 50% of your money it takes a 100% gain to get back to even but if you lose 90% of your money 3 consecutive 100% gains still won't get you back to even.