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This Fund Lost 94%, and Yet Could Have Been Useful

A bad gamble, but perhaps a good hedge.

Drama Queens For once, funds have been exciting!

The U.S. fund industry reached maturity a couple of decades back, and hasn’t done much of interest since then, aside from embarrassing itself with a market-timing scandal. To be sure, its CEOs have been fascinated; $2 trillion of net inflows will do much to catch an executive’s attention. But for Internet bloggers, seeking the strange and wonderful, the fund business has been no prize--until two weeks ago, when stock-market volatility

like a Calaveras frog, with the CBOE’s Volatility Index rising by 267% in one day. That unprecedented gain, combined with the invention of volatility-shorting funds (an exception to the general rule), caused what likely is the single greatest weekly loss in U.S. mutual fund history. (It certainly is the largest over the past 30 years; before that, weekly data is difficult to search.) The inappropriately named

Well, that was different. Even more unusual has been VelocityShares Daily Inverse VIX, ticker XIV (clever that). The fund--well, technically not a fund, being instead an exchange-traded note, but for practical purposes we can call it by the label of fund--is down 94% for the year to date, with almost all of that loss occurring in February. Its issuer, Credit Suisse, has seen enough. Declaring "no mas," Credit Suisse will retire the note on this upcoming Tuesday.

Unlike with the LJM fund, which follows an active investment strategy and which shocked its investors by cratering, XIV’s performance was not a surprise. XIV was crafted to make a whole lot of money when stock-market volatility declined, with the recognition that it could--and would--get stuffed when volatility rose. Suddenly, it could lose almost everything. There was no mystery; if the CBOE’s VIX index were to triple in two days, XIV would be in big, big trouble.

Bad Gamble My initial thought--I hadn't followed XIV until its catastrophe--was this was the worst fund I had ever seen. Typically, investors use specialized funds badly, by buying high after such funds generate headlines and then selling low into disappointment. The problem is exacerbated for highly volatile funds, which quite naturally attract even greater interest with their outsize gains, and even greater unhappiness when they plummet. XIV was a recipe for disaster.

My second thought was that my initial thought was correct. There were many ways to use XIV, almost all of them involving gambling. Wagering on a fund that could at any time go to zero is not something that strikes me as useful for everyday investors. Such a view, of course, is far from unique. In this article, my former co-worker John Coumarianos voices similar concerns.

Good Hedge? However, as Morningstar's Paul Justice points out, an argument can be made for XIV's usefulness, if used by professional investors. Wrote Paul in an email, "Harvard [criticized for following a volatility-shorting strategy that was similar to XIV's] could have improved its performance by owning this esoteric product that nearly evaporated in a single day. The example is counter-intuitive, but simple in form."

Indeed, Paul's proposed strategy is simple. On the day of XIV’s launch, Nov. 29, 2010, he formed a portfolio that consisted 90% of an S&P 500 fund, and 10% of XIV. He then rebalanced that portfolio each Nov. 30. The chart below shows the result for that portfolio, versus the unadorned index. The hedged portfolio grew the initial $100,000 investment into $332,230, while the S&P 500 finished at $265,462.

Source: Morningstar Direct.

The benefit would not have occurred without the rebalancing, because XIV’s previous heroics would have gone to naught with its February 2018 blowout. (As they say, nobody ever made a dime in the stock market without selling a security.) With the rebalancing, though, the 90/10 investor reaped the massive profits of XIV’s 155% return in 2013, 107% in 2013, 81% in 2016, and 188% in 2017. With gains of that magnitude, even a modest 10% stake supercharged the entire portfolio’s return.

Of course, these results occurred during a time of low and flat market volatility; had the trend been rising and fluctuating, XIV would likely have hurt the hedged portfolio, not helped it. On the other hand, the S&P 500 outgained almost every rival investment from 2010 until present. It is not as if Paul’s simulation uses a time period in which it was easy to beat the S&P 500. Quite the contrary.

Wrapping Up I do not know if Paul's 90/10 portfolio made investment sense in 2010. Did any professional managers use volatility-shorting strategies in such a fashion? Perhaps--but if so, I have not heard about that. Thus, Paul's spreadsheet might be a form of back-testing, to demonstrate what could have worked, but which was not implemented. No matter. For me, the example's lesson is sufficient. Although I continue to doubt that highly specialized, volatile funds are used well by most investors, and disapprove of them as a general rule, I must now concede that they contain some merit, even if that merit is theoretical. A fund that lost 94 cents on the dollar, benefiting a portfolio! I would not have thought I would see that day.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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