This stock's leavin'...on a midnight train to zero
Pardon the strange reference in my title, but I heard Gladys Knight yesterday and I've had her great song Midnight Train to Georgia on my mind ever since.
I came across a truly idiotic ETN yesterday. I've never really liked ETFs or ETNs, but this one blew my mind when I read how it works. If I understand this thing correctly, and I'm pretty sure that I do, it's almost guaranteed to be a losing bet over time. It probably won't ever hit zero like I alluded to in the title, but it very likely will be cut in half again, and again, and again over the next several years with a few reverse splits thrown in to mask the pain.
What ETF am I talking about? VXX, the S&P 500 Short Term VIX futures. For those of you who aren't familiar with the term, the VIX essentially measures the volatility of the market. The wilder the swings in the S&P 500 are, the higher the VIX will go. This idiotic thing lost 82% of its value in 2009, yet it still has a market cap of nearly a billion dollars.
Theoretically an ETF or an ETN that tracks the volatility of the market is an interesting idea. The problem is that this the way this specific stock works is flawed. VXX is not directly linked to the volatility index, instead it attempts to replicate its activity using a rolling futures portfolio. The way futures contracts usually work, longer term contracts are more expensive than short term ones. In this specific case, Mr. Market usually assumes that volatility will be higher down the road than it is today. The phenomenon of future contracts being more expensive than near term ones is called contango.
The fact that the VIX futures market is normally in contango means that every single month when the folks who run this ETN lose money when they sell the cheaper near term futures and roll the funds cash over into a longer term contract. Unless the market the market goes into backwardation (essentially the opposite of contango), and such an occurrence is much less common than contango, this fund will inherently lose money month, after month, after month. The chart at the top of this post illustrates how the VXX under-performs the VIX over time.
Of course there are exceptions to this rule. As I mentioned the futures market does go into backwardation from time to time and of course something wild like Iran going postal or crazy riots in Greece, etc... could cause a major spike in market volatility. Still over time, especially in CAPS where one can endure the pain of a temporary spike in volatility for free, I strongly believe that the inherent friction way it works will cause VXX to be a big loser. That of course means free points in the game that we all love.
The funny thing is that I came across this idiotic ETN late yesterday and I thought to myself who in the heck would ever buy this trash other than for a very, very short term trade? On the drive home from work, I was listening to Bloomberg radio and I actually heard one of the "advisors" that Pim Fox was interviewing recommend this dumb thing. Good grief.