As can be seen in the following chart, the ProShares VIX Mid-Term Futures ETF (VIXM) has largely held its ground following the historic rally in VIX earlier this year.
At present, I have to separate views on VIXM: a short-term view and a long-term view. In the short term (1-3 months), I believe that VIXM is likely going to spike once again. However, in the long term, I believe that VIXM is headed lower. Let’s jump into the various reasons driving these views.
Over the past 24 hours, we have seen momentum in the S&P 500 begin to wane.
As you can see in the chart above, the MACD indicator has turned negative for the first time since early August and only the fourth time since the downturn at the beginning of the year. The MACD is a relatively simple indicator which basically calculates the differences between two moving averages and it is used to gauge momentum in prices – when the shaded region below the chart is positive, momentum is positive, and the opposite is true when momentum is negative.
What is important to note in the above chart is that we have essentially seen the start of what is likely going to be a pullback. The extent of this pullback of course cannot be known at the onset, but we can very clearly say that momentum has started to diverge from the underlying price trend.
Again, we can’t know the extent of any given market movement before it occurs, but we can position ourselves to capture whatever specific market movements may come. For example, given that we are seeing bearish momentum develop against the direction of the trend, if we were long the market, we should look to tighten up stop losses and potentially brace for a prolonged downtrend.
However, when we are trading VIX, we are in effect trading a short S&P 500 position. What I mean by this is that as the market falls, VIX tends to rise.
In other words, given that bearish momentum is developing in the S&P 500, we should by default start to form up a bullish view on VIX. This may seem like very short-term thinking in that we have only seen a single day of bearish momentum; however, the math pretty clearly indicates that the shortest-term movements in the market are most heavily inversely correlated with changes in VIX.
It is important also to note what has driven this bearish divergence in the market: the FOMC meeting and subsequent discussion. The key takeaway from the meeting is that growth forecasts have been revised lower. Without getting into any of the specifics, the main reason why this is so bullish is likely psychological more than anything as it relates to the market: given that the market is at new highs and given that growth forecasts have been revised lower, market participants are likely going to “wake up” so to speak and revise positions accordingly.
It is my belief that we are in for a selloff in the S&P 500 which may last for at minimum 1-2 weeks based on similar selloffs in June. At this point I do not believe that the market will enter another major leg down; however, the clear correlations between VIX and S&P 500 show that even a drop of 5-10% in the market could result in a rally in VIX of 30-50%. In this type of environment, I do not want to be short VIX and therefore I recommend that investors not initiate short positions against VIXM at this time (if your investment time frame is 3 months or less).
However, for long-term traders of VIXM, I believe that this coming rally in VIX will likely serve as a very strong shorting opportunity.
If I could write this message in flashing red letters I would: an investment in VIXM is not the same thing as an investment in VIX. I assume that most investors reading an article about VIXM are at least aware of some of the underlying issues associated with an investment in VIX futures and can see some of the benefits of holding exposure further out along the futures curve. However, for those who are unfamiliar or don’t quite fully understand the implications of VIXM’s strategy, this section is for you.
Let’s start out by ripping off the bandage: here is the long-run performance of VIXM’s index as directly provided by S&P Global.
Assuming you knew nothing of the underlying asset in the above chart, would you ever invest in this instrument? At face value, I would have a very hard time actually putting money in something which has declined at an annualized rate of 20% for the past decade. And I would assume that most investors would be in the same boat – it makes very little sense to park money into an instrument which declines so strongly through time.
VIXM is following the S&P 500 Mid-Term VIX Futures Index. This index continuously holds a portfolio of VIX futures contracts which settle 4-7 months into the future. For example, here is the current table of holdings.
If you’ve read any of my coverage of this ETF before, then you’re likely aware of my main gripe with this methodology. The problem with VIX futures isn’t the rolling methodology – it is perfectly fine to sell out of one month of VIX futures and buy into another month of VIX futures. The problem is something called “futures convergence”.
Futures convergence is what happens when you’re holding exposure along a futures curve while the futures converge towards the spot price. This graphic from Wikipedia captures the idea perfectly.
What this graphic essentially shows is that if you are holding a futures contract, your return is actually subject to two things: the outright changes in the price of the commodity and the degree of convergence priced into the curve on any given day.
The huge implication in the above data is this: if you are holding futures contracts which are in contango (or above the spot price), then on average you’ll see losses from the convergence piece because the futures contracts you hold are declining in value in relation to the spot. And this is exactly the problem with VIX futures: they have been in contango for 85% of all days over the past decade. In other words, most of the time, VIXM’s holdings are priced above the spot level of VIX and therefore, most of the time these futures contracts are losing value to convergence.
This is why I am structurally bearish VIXM. I believe that futures convergence is almost certainly going to continue eroding wealth from shareholders, and VIXM is almost certainly going to continue dropping. The VIX really doesn’t go anywhere through time (stays around 15-20 most of the time), which means that this futures converge is the largest explainer of a long-term exposure to VIX futures and therefore, VIXM is likely going to continue dropping over lengthy time periods.
A case certainly can be made that VIXM can be used as a portfolio hedge (since it’ll rise when the market falls, on average); however, I believe there are better hedges (like stop losses and put options against positions). For this reason, I suggest avoiding long exposure to VIXM if your investment horizon is longer than the next 1-3 months.
The VIX markets are becoming more bullish as the FOMC meeting minutes indicate a further slowing of the economy while the market is near all-time highs. An investment in VIXM is not the same thing as an investment in VIX. Futures convergence remains the primary driver of long-run bearish returns in VIXM.
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.