I’m going to make this brief. And I’m going to start with a couple of caveats. The major caveat is that this is only a back test and as ever it is highly dangerous to forecast the future based on the past. The other caveat is that the specific features which make this strategy work (contango in the VIX futures and negative correlation between the ETFs XIV and TMF) may not persist in the future.
This strategy has worked during the period of the test because of two factors:
- Shorting the VIX has been profitable since VIX futures have been in contango 80% of the time. This means you can short the new front month at a higher level than the expiring month you are exiting. Technically speaking the market is in contango most of the time.
- The long bond during the period of this back test has had a negative correlation of -0.4 to the inverse VIX. The best way to short the VIX for the man in the street is to use an inverse VIX ETF such as XIV. For the long bond you can use an ETF such as TLT or a geared version such as the 3x geared TMF. Negative correlation means that over time (in back testing at least) XIV and TMF have tended to move in opposite direction. A loss on one instrument has tended to be mitigated by a gain in the other.
Without further ado I will proceed to the back test. As long suffering followers will know, I have ceased to “believe” in trading where there is a “probabilistic” edge and thus concentrate these days on letting the market give what it will give.
For the 3x geared long bond I have used TLT returns multiplied by 3 since it has a long price history back to 2002. For XIV (short the VIX) I have used actual returns of XIV backfilled by futures market data to 2004.
You buy XIV and TMF and rebalance each month. It does not seem to matter which day you re-balance on – a big bonus and a sharp contrast to many systems I have looked at.
I have used a simple risk parity weighting strategy and a 1 month look back period to assess volatility. The look back period is robust to varying this parameter but unsurprisingly CAGR declines somewhat as the length of the look back increases to 12 months.
I’m not going to comment further. This is a very high risk strategy and I am trading it in small size. BUY and HOLD of short VIX position over the period would have produced a similar CAGR but with a far higher volatility and drawdown.
This “system” or combination of holdings has in back testing produced an absolute and risk adjusted return far higher than the benchmark.
I will leave it to readers to ponder this monstrous scheme and draw from it whatever conclusions they wish.
Stat Inverse Volatility S&P 500 TR ------------------- -------------------- ----------- Start 2004-04-26 2004-04-26 End 2016-12-20 2016-12-20 Risk-free rate 0.00% 0.00% Total Return 7671.36% 160.47% Daily Sharpe 1.34 0.49 CAGR 41.07% 7.86% Max Drawdown -41.10% -55.25% MTD 3.93% 3.38% 3m -5.27% 6.69% 6m 2.87% 10.17% YTD 38.47% 13.50% 1Y 35.59% 15.74% 3Y (ann.) 27.83% 9.99% 5Y (ann.) 30.69% 15.28% 10Y (ann.) 32.64% 7.06% Since Incep. (ann.) 41.07% 7.86% Daily Sharpe 1.34 0.49 Daily Mean (ann.) 38.65% 9.41% Daily Vol (ann.) 28.94% 19.18% Daily Skew -0.38 -0.09 Daily Kurt 2.70 11.76 Best Day 11.09% 11.58% Worst Day -11.46% -9.03% Monthly Sharpe 1.31 0.63 Monthly Mean (ann.) 39.34% 8.76% Monthly Vol (ann.) 29.97% 13.95% Monthly Skew -0.34 -0.78 Monthly Kurt 2.54 2.26 Best Month 37.70% 10.93% Worst Month -28.46% -16.79%
Allocation over time between XIV and TMF: