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There's a new member to what is now a long list of ETFs/ETNs detaching from reality (their NAV). This new entrant is the VelocityShares Daily 2x Long VIX Short-Term ETN (NASDAQ:TVIX).

As with other ETFs/ETNs, the defining moment that allowed this irrationality to express itself was the suspension of issuance of new units by Credit Suisse. The issuance and redemption of units is central to the arbitrage mechanism that keeps ETFs/ETNs close to their NAVs (net asset values). This is so because if market demand tries to take a fund's quote much above NAV, the issuance of new units sates this demand and brings the price closer to NAV again, while if the market tries to sell the fund well below its NAV, the buying and redemption of units at their NAV pushes up the fund quote closer to NAV. Redemption of units is never suspended, however issuance sometimes is, namely if because for some reason, it becomes impossible to create new units economically or legally (when the issuance of new units would violate position limits on the underlying). In the case of TVIX, the problem that was happening was mainly that the VIX ETNs were becoming the market in regards to VIX futures.

Present Premium to NAV

Having detached from reality, it's obvious that at some point TVIX will present an arbitrage opportunity, especially because other similar VIX ETNs/ETFs, such as the ProShares Trust Ultra VIX Short ETF (NYSEARCA:UVXY) haven't done the same. A ratio of TVIX and UVXY thus illustrates this emerging inefficiency:

Click to enlarge

We can calculate TVIX's premium by comparing it directly to its NAV. To get its present NAV, we just need to search for ^TVIX-IV in Yahoo Finance. Doing this, we arrive at a premium of ($14.89/$12.59-1) = 18.3%, so TVIX is trading 18.3% above where it should, and would have to fall 15.4% to get back to its fair value.

It's Happening Elsewhere

A lot of ETFs/ETNs that stopped issuance are detaching from their NAVs, some incredibly so. Recent examples include Sprott Physical Silver Trust (NYSEARCA:PSLV), trading at a 7.6% premium; UBS E-TRACS Long Platinum TR ETN (NYSEARCA:PTM), trading at a 4.1% premium (care must be taken here, as Yahoo Finance is not updating the indicative value properly - the proper NAV can be seen here); and, most incredible of all, iPath DJ-UBS Natural Gas TR Sub-Idx ETN (NYSEARCA:GAZ), trading at a 104.4% premium.

Besides presenting possible arbitrage opportunities, these deviations from NAV also give us a strong piece of information: They tell us how the uninformed traders are leaning. This is so because only uninformed traders would ever pay a substantial price over NAV. So, it is perhaps no coincidence that most of the ETFs/ETNs that are trading at a premium to their NAVs are long commodities, showing that there's clearly a bias by uninformed speculators to be long commodities at this point (hence my article "Why You Should Step Away From The Commodities Table").

At the same time, though, the increasing premium on TVIX shows that there is also a throng of uninformed speculators betting on a higher VIX, which implies a bet on higher volatility and usually correlates with a correction on the stock markets. Interestingly enough, those two bets being made by the uninformed speculators can be somewhat contradictory, because a scenario with higher commodities would probably be accompanied by higher stock prices and lower volatility.

Conclusion

These are developments that clearly merit monitoring, with a view toward taking arbitrage positions at some time (short the ETNs that show excessive premium, long similar ETFs/ETNs or the underlying). GAZ is already at a point that merits such positions, or even just a straight short without a hedging position.

TVIX is perhaps still not at the point where it merits an arbitrage position - the premium can still easily inflate further. It will be interesting to see how it behaves if the market really undergoes some weakness and higher volatility, though it would seem that lower volatility would actually increase the premium faster. If at some point it inflates beyond 30-40%, it will probably be a good time to initiate arbitrage positions.

Source: TVIX: An Emerging Arbitrage Opportunity