The Parable of the Altruist God

Once there was a minor god. She didn’t have all the powers of God but she had a few tricks up her sleeve and one day she was given a planet to look after. It was a beautiful little world teeming with life. Since she was but a young god she was given a planet of plants to start. From a distance the world was an Eden but as the god looked closer she was dismayed with what she found. When she looked close she did not see a paradise, she saw a war.  She saw tall trees fanning out large leaves to take all the sunlight while small bushes, ferns and grasses withered and suffered below trying to find small pockets of light for nourishment. Every day while some plants flourished and grew others were dying of starvation or thirst. The suffering of the young was greatest. The vast majority of baby plants died before they reached maturity.

Seeing all this suffering and inequality, the god knew she must act. She did not have the ability to make nutrients out of nothing, but she was able to reallocate. She said to herself, “Those that have much should give to those who have less. Surely that will be more just and would increase total utility.”  So the god put a spell on the planet such that every living thing that had an excess of nutrients would have some of them magically transferred to those that were the most in need. Then she sat back to watch her little planet thrive and flourish.

Immediately the young saplings that were dying in the shade started to perk up and grow. The great trees gathered the sunlight but it was now distributed to all. Without excess energy they could grow no further but that was just a wasteful competition. Now so many more plants could live.

All the plants continued to age and die as was their nature. The god could not prevent that and even if she could, it was important to make room for the new on her little world. Since no trees could gather enough excess energy to reach great heights the tall forests of the planet were gradually replaced by a vast grassland. This was good, the god thought, since millions of little blades of grass could live in the sun that was once hogged by one great tree.

As millennia passed and the plants lived their lives the blades of grass that dominated the world grew thinner and thinner. For each little blade the work of growing their one leaf to capture as much sunlight as possible did not make much sense. If they could not support themselves then other blades with wider leaves would support them. They could spend their energy making more seeds since their offspring would also be aided by whatever grass still generated more energy than it absolutely needed to survive. Finally, grasses started to evolve that produced no leaves at all. Relying on the now ancient spell to provide them with enough nutrients to survive they simply put all their energy into growing more seeds.

While the total number of lives on the planet continued to increase the total energy captured from the sun declined.

When the end came it was swift. Suddenly, there was simply not enough energy left to support the lives of most of the plants. The spell worked furiously to transfer what energy that was available to those who were closest to starvation but it was only able to extend their starvation by mere seconds. The few remaining plants that could feed from the sun had to starve to support the multitudes that could not. In one final gasp the planet died as the last calorie was consumed faster than the next could be produced.

The little demon looked at her dead planet and said “There, now all is just. All is equal” and moved on.

Eulogy for XIV

This week we lost a truly special financial product. XIV was an Exchange Traded Fund (technically ETN but who cares) that sought to provide a daily return equal to the inverse of the daily return in the vix index. The vix index is an index constructed from the implied volatility of SPX options. So, basically vix is a measure of how volatile traders expect the stock market to be, or alternatively how nervous people are about stocks.  When volatility or expectations of volatility of general nervousness went down then XIV went up and vice versa. That seems pretty boring until you consider the unique features of volatility as a trade-able instrument.

I. Behavior Of Volatility

Unlike a stock or commodity that can go up forever or down to $0, volatility spends most of the time being low and occasionally and temporarily spikes.  Over the long run we see that vix tends to hang out around 12 or so. Sometimes it can be higher for an extended period of time, like during the 2008-2009 financial crisis, its floor seemed to be elevated to more like 20. Sometimes it spends a few years never getting much above 10. When there are big market moves or events, it can spike up into the 30s, 40s or even I think 90 at the peak of the financial crisis. But every time it goes up it crashes right back down again in a short period of time. Now, naively you might think that if it never gets much below 10 and occasionally goes way higher then the smart and obvious strategy is just to buy it when it’s low and then wait and sell when it spikes. After all, if you buy for 10 and a year later its 10, you haven’t lost anything right? Actually that’s wrong and that is part of the magic of XIV.

II. Volatility Term Structure

XIV and other volatility-linked ETFs relied on vix futures listed on the CBOE to get the exposure they wanted. Vix futures have the feature that they expire on a monthly basis so if you want to constantly stay short or long vix you have to frequently roll from the future that is expiring to the next future. XIV would move a fraction of its position from the closest to expiration future to the next future every day. So right now if it was still operating it would be moving a few% of its portfolio from the February future to the March future. When February ended it would start moving the March futures to April etc. By moving I just mean it would need to buy some of the February futures that it was short and sell the same number of them in the March contract. The very interesting thing about the vix futures is that when volatility is low the further out contracts are always priced higher than the closest to expiration contract. Why would this be? Well, it has to do with the difference between median and mean. Median is the value that a variable spends half its time above and half its time below. Since volatility is low most of the time, the median value of the vix is pretty close to its lowest values. The mean is just the average of the values that the variable takes on over time, so the mean value of the vix is higher than the median because sometimes you get those big spikes. The longer a future has before it expires the more likely it is to be worth the mean (in a stationary process like the vix). So when volatility is below the mean (which it is most of the time) the further dated futures will be higher than the closer dated ones. When vol spikes up then you see just the opposite. The long dated futures don’t diverge too much from the long term mean but the short dated ones really rip higher to reflect the short-term spike.

III. The XIV Strategy

So when XIV constantly rolled its exposure from the front month to 2nd month future, it would constantly be buying at a lower price than where it sold. The difference between the months was substantial. In 2017 typically the front month was around 10 and the 2nd month was around 11. So each month as long as volatility and the term structure remained constant XIV would earn about a 10% return just from rolling its position. Over the course of the year XIV earned almost 150%. And for any extended period when volatility stayed low it could earn these amazing returns. Overall from 2012 until the day before it blew up it earned nearly 1000%, vastly outpacing the stock market. So you could buy it and hold it and have a great ride but you had to be aware that the ride was going to end with it crashing into a brick wall at some point. Volatility always spikes eventually and eventually it would have a big enough spike to wipe out all its capital. The long term probability of that occurring was 100%. So, what do you do with a product like that? Its not really that difficult. Suppose that you  put $5,000 into XIV a few years ago, and then whenever your XIV position reached $10,000 you sold off half of it. Over the course of the last 5 years or so you could have sold half your position at least 3 times. So, even though your original $5,000 investment is gone now, you would still have the $15,000 in cash. That still beats most other investments including the stock market over that period.

IV.  The Real Magic of XIV

Now you might say, sure XIV is gone now but there are still vix futures and there is still VXX which is an ETF that positively tracks the vix. You could sell futures or sell VXX. That’s true but its just not as good. Suppose that you are short vix futures on Friday afternoon and they are trading for 10. On Sunday Kim Jong Un’s iphone crashes while he is about the answer the 15th question right on HQTrivia so he decides to Nuke San Francisco.  You can imagine any horrible event you wish. On Monday morning the stock market is down 30% or whatever and vix is up to 100. Now you have not just lost the notional value of your future on Friday, you have lost 9 times that much!  If you don’t have enough capital to cover your losses you could be forced to get out of other positions. If you had 10% of your money in XIV you could go to bed knowing that no matter how much volatility spiked that was all you could lose. If you had 10% of your money short VXX or vix futures you could potentially lose most or all of your net worth.  That is what made XIV a truly magical product.

V. So Who Would Have Ended Up Paying? 

XIV had about $2 Billion of exposure when it blew up. Considering the scenario where vix closed at 10 on Friday and opened at 100 on Monday it would have lost $18 Billion. The holders of the ETFs would be out their $2 Billion but who would absorb the rest of the loss? Someone would have to! I’m not 100% sure of the answer, but it seems like it would either have to be the exchange that offers the vix futures or the financial institution which managed XIV, or some combination of the 2. In any case, those companies were making tiny amounts of money in exchange for shouldering that enormous risk. While an XIV holder could make 10%/month in a low volatility environment, the management company (Credit Suisse) was making something like 0.5%/year! The CBOE was only making the transaction fees on the futures trades which are something like 0.01% of the value of each future. Because of this potential for explosive harm, its amazing that this product ever existed. And now that its gone and Credit Suisse will probably spend most of the money it ever made from it defending lawsuits from people who owned it. So, I’m sad to say that I don’t expect it to come back any time soon.

What to do about Stagnation

For the last 6 years or so my expectation of the future direction of humanity has been dominated by “The Great Stagnation.”  In it Tyler Cowen clearly lays out the empirical case that economic growth has slowed significantly since the mid 20th century. While Cowen believed that growth would eventually return to the levels of the 20th century I was less sanguine. We know that 2% exponential growth cannot continue forever.  In 10,000 years at 2% average real growth we the world economy would be 10^86 times larger than it is now. 10^86 is around the number of atoms in the visible universe, so each atom would have to be producing as much economic output as the whole world does now. I find that implausible. So, the simplest model is to draw a line from our current level of growth down to 0. There should be some volatility around that downward sloping line but there is no reason to assume that it will ever return for a long period of time to the highs that we have achieved in the past.

When I put it that way, I still find it fairly persuasive. In the very long run we simply cannot have fast exponential growth. My personal and emotional takeaway from this fact was that I and my progeny should focus on zero-sum status games. In the long run, zero-sum games have to be much more important than progress. There is an infinite amount of fighting that can be done about how the pie should be divided but the size of the pie will always be finite. So doesn’t it make more sense to focus on doing well in the fight rather than trying to grow the pie? I’m not so sure anymore.

Consider Elon Musk’s accomplishment yesterday. He inspired the world by launching a car into space on a rocket that isn’t nearly as powerful as ones that existed 50+ years ago.  The main innovation that SpaceX has accomplished is to get rocket stages to do controlled descents that allow them to be reused. Its amazing to watch the booster rockets land and it should, in theory, lower the cost of delivering cargo to space, though not to the point where we can do a lot more useful things. Its not the kind of innovation that is going to add a lot to global growth, but it might inspire some people to buy Tesla’s and that would be a big win for Musk.  Innovation inspires people. It gives people hope. Its a great strategy for getting yourself a bigger piece of the pie. And beyond its effectiveness as a cynical mode of separating hopeful people from their money, its personally satisfying to feel like you are contributing to human progress. Waking up every day feeling like my only mission was to redirect resources to me and my kids was getting pretty old frankly. Time to start trying to actually make the world a better place.