EC Replacing Stocks With Volatility?

Stock replacement strategies attempt to replicate equity performance without directly investing in the stocks they seek to replace. A popular example of this is buying deep-in-the-money call options (or 1.00 delta options) such that the price of the options will increase by $1 for every $1 increase in the underlying stock price. In-the-money options can in this way deliver the same type of exposure to a stock for a lower upfront cost than actually buying the underlying stocks, and can simultaneously reduce the risk exposure of a portfolio. Imagine a $20 strike call option on a $50 stock; if the stock were to fall to zero, the $20 strike option in the stock replacement strategy would only stand to lose its premium (say $35), while a traditional long stock position would lose its entire $50 value.

But option buying is not the only way to gain equity type exposure while managing risk. Another less known strategy is to replace equity exposure in a portfolio with a smaller, Beta-adjusted exposure to a high Beta stock. For example, trading in the VelocityShares Daily Inverse VIX ST ETN (XIV) has grown in popularity as it has considerably outperformed major US equity indexes in the present bull market. Presently XIV’s 5-year monthly Beta to the S&P 500 is 4.78, which given its significant outperformance, seems to make sense.^[1]

But let us look a little closer at the XIV vs. equity performance. In making a comparison I’ll use the S&P 500 Total Return Index (SPTR) rather than the S&P 500 Index (SPX) because over a 5-year period the value of the dividends from the SPX do make a meaningful difference to the investment’s performance. Over the last five years, the SPTR has gained 93%, while over the same period the XIV has gained around 456% – a return very close to what the Beta to the SPX would suggest.^[2] So could an investor with $100 invested in the SPTR have done better with $21 (beta adjustment of 100/4.78) invested in XIV? Well, possibly.