The price of ETFs and ETNs based on a long “rolling” position in futures often deviate significantly from the commodity or index that the futures are based on because of positive or negative roll yields. When the roll yield is positive than it adds to the return of the ETF or ETN and investors are happy, but when it is negative it can cause the ETF or ETN to become useless for anyone but short term traders. One area where this has been particularly the case is long-volatility products.
Recently, Barclays Bank launched the iPath Dynamic Volatility ETN (XVZ), an ETN intended to provide exposure to volatility through vix futures while at the same time managing the roll costs that have plagued most other long-volatility products. Because this is one of the first products to try to solve the negative roll yield problem, I thought it would be instructive to look at how the underlying index is constructed.
The index it is based on, the S&P Dynamic VIX Futures index, adjusts its exposure to the S&P Short Term VIX Futures index and the S&P Mid Term VIX Futures Index, depending on the term structure of VIX futures. To determine the exposure to each index, it uses a ratio of the CBOE Volatility Index to CBOE S&P 500 3 month Volatility Index to represent the implied term structure and then allocates according to the following table.
(source: index methodology)
When the implied roll yield is roughly zero the S&P Dynamic VIX Futures Index only holds the mid term futures index, a position which is reduced when the implied roll yield is higher or lower. When the implied roll yield is higher it takes a long position in the short term futures index and when it is negative, a short position. Because the roll yield of the short-term futures index is affected to a larger degree by a sloped term structure than the mid-term futures index, it is able to cancel out much of the negative roll yield of the mid term futures position when the implied term structure is upward sloping, and increase the positive roll yield when the implied term structure slopes downward.
In my opinion, this method for solving the roll yield problem makes this ETN the best product out there for longer term investors to be long volatility. So far, all other long-volatility products have been affected too much by an unfavorable term structure, and are more suitable for traders than long term investors.
Currently, the iPath Dynamic Volatility ETN is small with only a little more than $4 million in assets, and trading volume is light, so care should be taken when trading and limit orders are probably a good idea. It has an expense ratio of 0.95%, which is a bit higher than normal for ETFs and ETNs, but it should be worth it given the benefits of its roll yield management.
