I have been going on about roll yield and term structure for a few posts, and through two very concrete examples we’ll see how it can affect your trading and system development
A reader recently mentioned a paper (pdf by Sloyer and Tolkin) presenting a theoretical trading strategy which improves the risk-return profile of standard equity-bond portfolio by adding allocation to equity volatility represented by the VIX index. The idea sounds good on paper (no pun intended), but a “small” assumption might render the strategy impossible to implement practically:
VIX futures can realistically be included as an asset in a passively managed portfolio as the futures can be rolled relatively cheaply from one contract to the next as each contract expires.
Taking a look at the current VIX futures curve clearly invalidates the assumption above:
At the current levels, the contango rate is over 100% annualized – definitely no “relatively cheap” roll yield. As we’ve seen with the contango exhibited in Crude Oil in 2009, futures performance failed to match the spot price – and with such a high contango rate in the VIX futures, the same would happen: spot price returns would be “eaten away” by the negative roll yield. Indeed, prices would have to raise by an annualized 100% just to counter the contango.
Sometimes a good theoretical idea fails at the practical implementation stage…
Coincidently, another reader was offering me a friendly warning regarding the use of spot market to drive signals for a futures trading strategy – as was described in Better Trend Following through improved Roll Yield (note: for practical reasons, the test in that post was done using front-month contract as a proxy for the spot market).
In effect, as is the case in the VIX futures, the roll yield part of the total return sometimes trumps the spot price moves. In these cases, looking solely at the spot market can be flawed.
This is very well illustrated by this Peso chart sent from our reader:
The strong divergence between both series meant that an investor/trader going short on the Peso, would have been “right” (ie. the Peso unarguably went down), yet would have lost money if using futures to implement her trade (as highlighted by the futures continuous contract going up).
This is another case where the roll yield has a stronger impact than the spot price move.
Despite the spot price usually grabbing most of the attention, the roll yield can be the driving factor to a futures market’s total return. This can seem counter-intuitive but on long-term timeframes, roll yield explains most of the market’s performance (as discussed in this separating the wheat from the chaff paper I have linked to previously).
When looking at potential trades (in futures, or ETFs, which are sometimes no more than futures “wrappers” or even forex with cost of carry), one should weigh the spot price return potential against the term structure implied return. From a system development point of view, an idea might be to add a portfolio ranking/filter based on the implied yield vs. ATR (or other measure of “volatility”).
The second conclusion is that the market seems to reward those who trade against conventional wisdom. In that period covered by the Peso chart, most people were worried about further devaluations and were paying dear to hedge against this outcome. The hedge ended up costing them more than the cost of holding on to a devalued Peso. Alpha is finite and flowed to the minority being long the falling Peso…
Maybe time to short the VIX futures?