Over the years, I’ve invested in all sorts of companies around the world. Some investments have worked, some haven’t. At all times, I try to learn from my mistakes—the more expensive, the more memorable. If you do not learn, you will continue making the same mistakes. Which brings me to a comment from a successful friend, also smarting from Barclays Bank PLC iPath Inverse January 2021 S&P 500 VIX Short Term Futures ETN (IVO:Amex) losses. “Why did a bunch of value and growth investors suddenly decide that they knew the correct price and shape of the S&P 500 volatility curve?”
Warren Buffett famously talks about the concept of a “circle of competence.” This is a zone of familiarity where one should invest. Then there’s everything else which is in the “too hard pile.” I’ve made a career of buying underappreciated businesses around the world. Frequently, these are rapidly growing successful companies that are either unknown or misunderstood. This is my circle of competence.
The idea of the volatility futures curve existing in a state of contango and decaying at a high single digit monthly rate is quite fascinating conceptually to me. The majority of the time, this curve is in contango and a product like VXX will decay. From time to time, the volatility curve is backwardated and VXX appreciates for a few weeks or months. When that happens, it is painful, but as an investor, you can rest assured that such a period will be short lived—if you have the balance sheet room to ignore these spikes, you will consistently make money. In order to have enough balance sheet room, a short position in VXX has to be sized quite small as there is no way to know the amplitude of the spike.
IVO was a different sort of product. It was essentially the ownership of a fund whose only asset was a short position in VXX. IVO ran out of balance sheet room to hold onto its VXX short. Once the equity in the vehicle began to get chewed through, it essentially had a margin call and was terminated at 11.78. I realized this could happen, but I also didn’t expect VXX to appreciate to a level where IVO would terminate—shame on me. In the end, volatility is an abstract value dictated by fear. I clearly have no way to quantify the correct value of fear, or decide when it is overpriced. My analytical skills are useless in such a situation. Over time, the VIX will be mean-reverting, however, in the short term, just because it has doubled, that does not mean that it cannot double again first.
I originally bought IVO because I didn’t want to add to my VXX short position and take on the unlimited risk that could potentially occur if the VIX had a truly blow-off spike. In that regard, IVO worked just right in limiting my losses. On the other hand, I wish I had simply kept my original VXX position which would have served me fine. Over time, VXX will effectively decay to zero—an asymptote if you will. You simply need the room to hold on as there are some wild spikes along the way. I’ve now replaced my IVO with long dated VXX puts. I’ve also added a mental note that going forward, I will go back to keeping my short volatility position at a very small size. There’s a reason that I do not short. A very small short in VXX is pretty much my only exception to that rule. Even though IVO was a long position, it was really just a short in disguise.