Designed To Fail...

April 28, 2010 7:21 AM

I’m sitting here watching CNBC fill airtime with stories of how Goldman Sachs created securities that were designed to fail. We are supposed to feel sorry for the wealthy and financially savvy institutional investors who bought these things without doing their due diligence. This was a closed game that only a few very large investors were even invited to participate in. If you don’t understand the product—don’t invest.

Meanwhile, there are plenty of securities created by Wall Street, designed to fail and peddled to your average retail investor. There are no hearings about these. Let’s play Goldman Sachs, short them and wait until they go to zero.


My favorite of these is the iPath S&P 500 VIX Short-Term Futures ETN (VXX:AMEX). Theoretically, VXX should roughly track the CBOE Volatility Index (VIX Index). Then there’s reality. This product owns a combination of the front month VIX futures contracts and the second month VIX futures contracts. As of April 26, 2010, it owned 78% May futures and 22% June futures. It will slowly roll those May futures into June futures and then from June into July and from July into August ad infinitum. Sounds simple enough--except, you really don’t want this to happen if you’re long.

The VIX curve is almost always upwards sloping. The majority of the time, most of the contango is contained in the front few months and the curve flattens out in the back months. Look at where the futures prices are as of the close today, April 27, 2010.

  Current Price % Increase To Next Month's Price
May VIX Futures 21.1 6.2%
June VIX Futures 22.4 5.4%
July VIX Futures 23.6  

Every time this contract rolls from the current month to the deferred month, you are paying up 6.2%. That means that if you own 100 May VIX futures, you will only own 94 June VIX futures then 89 July VIX futures. Pretty soon, you own nothing. That’s before you pay the .89% yearly expense ratio. Did I mention tracking error and slippage? This product was designed to disintegrate. Look at a two year chart of the product since inception.

VXX started trading on Jan 30, 2009 at a starting price of 100. On the same date, the VIX was at 42.6. A year and change later, the VIX is at 22.8, or a 46% decline. VXX is at 20.6 or an 79% decline. The VIX will bounce around over time. VXX will continue to decay a few percent a month beyond the performance of the VIX.

Talk about a product designed to fail. That’s essentially what has happened. That is what will continue to happen because the product is poorly designed. Shame on Barclays!

The only time that VXX does not decay is when there is a sudden spike in the VIX. When the spike is extreme enough, the term structure of the VIX goes into backwardation and you begin to own more VIX futures contracts. Let’s just say that this rarely happens. Even when you begin to earn more VIX futures contracts, it is short a lived phenomenon—a few months at most.   

VXX Chart

I’m not saying that the VXX will trade in a straight line to zero. There have been numerous extremely volatile spikes higher. It’s a trader’s product. It should NEVER be owned. If you are brave enough—it should be shorted

I hate to short. It’s tough and when they go against you, they make you lose sleep. When I do short something, I do it small and try to be patient. Unlike most shorts, I’m keeping this one extra small. The nature of this beast is that if there’s bad news or something whacky happens in the world, this could scream higher. There’s a decent chance that every few years, this will double on the open. That’s when I intend to really pile in. For now, this needs to be kept small. However, over time, VXX will go to zero. It’s a rigged game.

There will never be hearings. Hopefully I won’t have to go to Capital Hill and explain why I’m short this product that Barclays is marketing to people as an investment. I feel bad for those poor retail guys who own this thinking it’s down 80% and ‘cheap.’ Maybe they’ll get a quick gain at my expense—but over time, VXX will continue to decline. Fabrice Tourre would be proud.

Categories: Current Investments
Positions Mentioned: VXX
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