Monday marks the first day of trading for the iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN (NYSE:VZZB), a new exchange-traded note that will offer leveraged exposure to an index comprised of mid-term VIX futures. The underlying volatility benchmark consists of four-, five-, six- and seven-month futures contracts on the CBOE Volatility Index (better known as the VIX), and VZZB will deliver returns that correspond to the 2x leveraged return of that benchmark over the life of the note. Unlike ETFs that may operate indefinitely, exchange-traded notes are debt instruments that feature pre-determined maturity dates. VZZB will mature in July 2021.
If VZZB sounds familiar, that’s because it is essentially a resurrection of VZZ, which shut down earlier this month after the automatic termination threshold was hit. Holders of VZZ are scheduled to receive their automatic termination distribution ($10 per share) on Monday as well.
VZZ shut down because the intraday indicative note value fell below 33.33% of the original per ETN principal amount. After debuting at $30 in late 2010, VZZ had dropped below $10 on July 1 after a quarter-ending equity market rally sent volatility indexes tumbling to levels well below their long-term averages. VZZB will maintain a similar automatic redemption feature. If the price drops below $10 per share, Barclays will automatically redeem the notes.
VZZB in Focus
The new ETN will offer exposure to futures linked to the VIX index, a widely followed benchmark that reflects expectations for short term volatility in U.S. equity markets (specifically, the S&P 500). Because the VIX tends to rise whenever concerns over the health of the U.S. economy intensify, volatility has become appealing as an asset class to some investors thanks to the strong negative correlation with stocks. While a direct investment in the VIX isn’t possible, innovations in recent years have made it possible for investors to gain exposure to the “fear index” through futures contracts.
The index to which VZZB is linked will consist of mid-term VIX futures contracts - those maturing in four to seven months. That can mean a big difference relative to benchmarks consisting of VIX futures that are closer to expiration. Generally, mid-term VIX futures won’t be as vulnerable to the adverse impact of contango as their short-term counterparts. Contango is generally steepest at the short end of the maturity curve. The trade-off comes in the form of diminished sensitivity to changes in the spot VIX. When that benchmark jumps, short term futures tend to gain more than their longer-term counterparts.
Nuances of “Lifetime Leverage”
VZZB will offer 2x leverage to the underlying index over the lifetime of the note - or about 10 years. That type of leverage differs from the vast majority of leveraged ETFs, which reset exposure on a daily basis (the exposure offered by VZZB will never reset). The result is that the effective leverage offered (meaning the amplification that can be expected if the note is held until maturity) will likely deviate from 2.0. When VZZ triggered its automatic redemption, the participation ratio (which is essentially the effective leverage multiple) had climbed to about 3.5. So it’s important for any investor considering VZZB to take a close look at that metric and understand the degree of volatility that can be expected in various environments.
“Our leveraged and inverse ETNs are designed with a leverage factor that is locked in at the point of purchase, reflecting returns that more closely track the index without path dependency over periods longer than a single trading day,” said Johnny Wu, head of Investor Solutions, Americas, at Barclays Capital. “The launch today demonstrates our ongoing commitment to providing investors with efficient access to the U.S. volatility markets, without tracking error or resets.”
A look at some of the existing leveraged ETNs from iPath helps to understand exactly how this nuance in the product structure translates into risk/return profile. Because equity benchmarks such as the Russell 1000, Russell 2000 and S&P 500 have performed relatively well since the products below launched, the participation ratio of the long ETNs has declined from the original level of 3.0. Among the short products, however, the participation ratio has skyrocketed. RTSA, for example, was recently offering leverage of greater than 8x (inverse) on the Russell 2000.
|ROLA||Long Extended Russell 1000 TR Index ETN||2.38|
|ROSA||Short Extended Russell 1000 TR Index ETN||6.84|
|SFLA||Long Extended S&P 500 TR Index ETN||2.39|
|SFSA||Short Extended S&P 500 TR Index ETN||6.50|
|RTLA||Long Extended Russell 2000 TR Index ETN||2.32|
|RTSA||Short Extended Russell 2000 TR Index ETN||8.41|
|As of 7/8/2011|
VelocityShares offers a product that is generally similar in some ways and very different in others. The Daily 2x VIX Medium Term ETN (NASDAQ:TVIZ) offers 2x leveraged exposure to the same index underlying VZZB, but resets exposure on a daily basis. The effective leverage offered will deviate from 2x throughout the course of a single trading day, but at the end of the session the exposure will reset.
Disclosure: No positions at time of writing.
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