The Black Swan Siren Song

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

There are few things more alluring in the investment world than the thought of predicting and profiting from the next black swan. Shorting, buying out of the money puts, going long volatility – betting on the next crash – is unbelievably tempting. If you’re right, the payoff can be immense and you’ll be one of the few to reap the rewards; more satisfying for many: everyone else will be losing money and wrong.

There is no greater feeling in markets than being right when everyone else is wrong.

But calling the next crash – even when you’re right – is a tricky business to say the least. Timing is everything when it comes it predicting financial Armageddon, as we saw in the movie “The Big Short.” And as black swans are by definition extremely rare, getting the timing right can be unbelievably difficult.

But that doesn’t stop many from trying, for the siren song is too great.

With the 2008 financial crisis fresh in our minds, ETF providers did what they do best: create products designed to fight the last war. Appealing to our most basic human emotions (recency/hindsight bias), the long volatility product was born. Going long volatility would naturally have produced unbelievable returns in 2008, particularly in October when the VIX Index peaked at just under 90.

The first ETN created in the space is still the largest by assets today: the iPath S&P 500 VIX Short-Term Futures ETN, or more commonly known by its ticker – VXX. This ETN offers exposure to a daily rolling long position in the first and second month VIX futures contracts.

VXX was launched on January 29, 2009. These are the calendar year returns since inception:

2009: -66%

2010: -72%

2011: -6%

2012: -78%

2013: -67%

2014: -26%

2015: -36%

2016 YTD: -21%

Overall, VXX is down 99.75% since it began trading. (In case you’re wondering, to get back to even after such a loss you would need a gain of 39,900%).


When I tweet out these data points and charts, the immediate response is some combination of the following:

“You’re a moron, Charlie. Don’t you know these are short-term trading instruments that are only used tactically or for hedging purposes? No one actually holds these things. I’m a pro that has traded the VXX for years and made tons of money.”

I know better than to try to have an intelligent discussion via Twitter, so let’s evaluate the validity of this response using actual data.

The VXX ETN currently has assets of $1.4 billion and has averaged $1.1 billion in monthly assets since its inception in January 2009. There are many traders that are holding this security overnight, praying for the next black swan. That is not my opinion but a fact.


How much money has been lost betting on black swans using VXX over the years? It’s impossible to say, but we can do a crude calculation.

Cumulative losses = Sum of (prior day ending assets * daily % change).

Using this formula, approximately $5.5 billion has been lost since the inception of VXX.

Now, this loss assumption is only based on the ending assets for the day. The volume in VXX is extremely high, and on any given day it can actually exceed the entire assets of the fund (this is very rare for any security, including ETFs/ETNs). For example, on February 11, VXX entered the day with $673 million in assets. $3.9 billion in VXX traded that day ($ volume) and assets ended the day at $673 million.

Does this mean that the $3.9 billion traded that day was minting money in VXX? Not likely. Why?

Because the intraday activity in VXX that day (-0.6% from open to close) was typical of an average day in VXX. That is to say, VXX usually trends down throughout the day, with an average daily open to close return of -0.21% since inception (-99.15% cumulative). This is not all that different from its daily return (close to close) of -0.25% since inception (-99.75% cumulative).


It is very hard to make money day trading a security on the long side with that type of profile, so I’m going to assume that the intraday volume multiplied by the intraday return (divided by 2 to account for average entry price) generates additional losses of around $1 billion.

This brings the total estimated losses in VXX to roughly $6.5 billion.

A Quick Note on Contango and Negative Roll Yield

Why has the VXX done so poorly? Two reasons. First, volatility has declined over the years from historic levels in 2009 when the ETN was launched to the low teens today. Second, and more importantly, is the negative roll yield from VIX futures. Remember, VXX is not tracking spot VIX but is comprised of first and second month futures contracts. The VIX futures curve spends most of the time in contango, meaning the futures price is generally above the spot price (see chart below).


At the end of each day, VXX is selling some of the first month futures and buying second month futures. Typically, given the term structure of the futures curve (contango), it is selling lower and buying higher. This results in a negative roll yield for the fund that compounds over time. (Note: traders going long the VXX are betting on a rise in VIX futures and shift in the term structure to backwardation, where futures prices are lower than spot prices. This condition will occur during sharp equity market declines (happened in January/February of this year) but with much less frequency than the normal term structure of contango.)

The Big Long

The VXX story is just one example of money lost in hopes of catching the next black swan. There are many other products traders use to chase this dream.

From my perspective, the VXX example is fascinating for a number of reasons. But most of all is the fact that it continues to decline in value but is able to replace its assets, again and again. The dream of another 2008 is apparently alive and well for many. This is true in spite of the bull market that is now over seven years in duration and in spite of the big long, the U.S. equity market, more than tripling in value during that time.

For long-term investors, betting on positive equity returns over time is a bet rooted in probabilities. There will be recessions and there will be corrections, but your expectancy is a positive return if your holding period is long enough. Simply put, the odds are skewed in your favor, just as the odds of timing the next black swan are skewed heavily against you.


Forgetting the Swans and Playing Defense

In our research and investment strategies, we focus a lot on volatility and have uncovered various anomalies that tend to anticipate periods of higher volatility in stocks (click on link to download: Utilities, Treasuries, Lumber/Gold, and Moving Averages). Through our research, we have found that there are many different ways to position defensively ahead of periods of higher volatility (lower beta sectors, lower volatility stocks, Treasury bills and bonds, etc.), but the key to this defensiveness is a position that will not bleed you to death when you’re wrong.

We are often asked why we don’t use short positions, put options, or long volatility plays if our strategies are built on anticipating periods of higher volatility. The reason is simple. Because they are not optimized for perfection, the volatility indicators don’t “work” all of time when looking back at history, only on average. This means they will inevitably be wrong in the future and sometimes very wrong. During such times, if you are short the market, long volatility, or buying put options you are eroding capital at a rate that is hard to recover from, even if the black swan does eventually come (remember the 39,900% gain needed for VXX to break even).

We have found that playing defense in lower beta sectors and Treasuries allows you to be wrong without a permanent impairment of capital. It’s not nearly as intellectually satisfying as timing the next black swan, but a more sensible investment strategy that you can actually stick with over time. Overall, the best way to avoid the call of the siren song is to have a diversified investment portfolio and stick to it with the knowledge that in the long run it will be leaps and bounds above a strategy withering away chasing the illusive black swan.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

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