As the ETF industry has rapidly expanded, so too have the options investors have for slicing and dicing markets. One of the most popular innovations in recent years has been the ability to access volatility through the exchange-traded structure; there are now multiple ETPs for gaining exposure to VIX contracts, including a number of inverse and leveraged notes and funds. The past week has seen some bizarre developments in one of the most popular VIX ETNs, offering a lesson in the potential dangers in dabbling in exchange-traded products whose “creation mechanism” has been temporarily switched off.
TVIX In Focus
The VelocityShares Daily 2x VIX Short-Term ETN (TVIX) offers leveraged exposure to VIX contracts; the note is linked to an index comprised of front month futures with a 200% leverage on the movements in volatility. As such, TVIX is obviously a risky product; it is not uncommon to watch it move by upwards of 7% in a single trading session. Not surprisingly, traders and sophisticated investors love the ETN, as it offers an extremely powerful way to make a speculative bet on the market. The fund, which has an ADV of about 12.4 million shares, trades more than 30% of its shares every single day, proving that it is certainly not a product for the buy and hold investor.
On Thursday, March 22, TVIX lost 29.3% of its total share price as investors scrambled to sell off their positions. The following trading day saw losses that were even more severe, 29.8%, as the fund was then trading at $7.16 per share. The net losses of the two days (after closing at $14.43 on Wednesday) totaled out to just over 50%, a massive swing that left many with big losses in a matter of hours. To some, the movements made little sense, as VIX futures had actually appreciated on Thursday, a move that should have sent TVIX higher. But a quick look under the hood shows a glaring issue that many should have been privy to prior to taking a position.
Behind The Scenes
First and foremost, it is always necessary to check how an ETP is behaving with regards to its NAV/IIV prior to investing. As many are aware, ETNs do not incur tracking error, but that does not mean that their price cannot stray from their NAV, as exemplified by TVIX. This ETN stopped creation of new shares in mid February, which ultimately led to higher prices as a result of limited supply.
Tracking error relates to an ETP’s indicative value, or what the underlying assets or note is actually worth, which TVIX perfectly tracked. The market price of the fund is what got out of whack, and this was simply due to investor speculation and big trades; TVIX had no issues with tracking error. There is nothing an ETN can do about its market price as it is impossible to control the herd. Instead of looking at just the market price, investors should look at the discrepancy between indicative value and the price of an ETN to examine premiums and discounts.
To give a real life example of what happened with this ETF, think of your favorite Apple device; if production on iPads halts for a month, the price of those left on the market will skyrocket despite not being truly worth the new price tag. Once Apple announces it has resumed production, prices plummet back to their original figure as demand can now be met with supply–simple economics.
For the past month, TVIX has strayed from its NAV until it all came to a head at the end of last week. Its premium, which had topped 50% at one point, was quickly erased as a massive sell-off took place with very curious timing. Just after the sell-off, Credit Suisse announced that it would resume creations of the fund, a move that would bring the fund back in line with its NAV. That does not necessarily mean that the sell-off was due to insider trading, but the timing and the manner in which it took place is certainly suspicious.
To put things as simply as possible, the note was trading way above its value and arbitragers stepped in to reap the rewards, though an investigation in to this behavior could very well emerge in the coming weeks. Anyone who checked into the indicative value of TVIX would have seen that the note was trading at a significant premium. For a comparison as to how much the premium impacted TVIX, we will compare it to UVXY, a fund with a near-identical same strategy.
(Click to enlarge)The chart reveals a clear trend; once creations on TVIX were halted, the fund began to stray from its value, floating at a massive premium, one that was swiftly and painfully corrected. To be clear, the indicative value of TVIX behaved exactly the way it was supposed to, but once creations halted, investor behavior put the fund out of line and created this issue. As of Monday, March 26th, TVIX is still at a premium of roughly 5.8%, something investors need to keep an eye on. It should also be noted that if TVIX trips the $5 per share line, it will likely undergo a reverse split.
A Word Of Caution
Many investors simply assume that they know what an ETP is just by looking at the name and index, but there is a lot more to it than that. With your standard equity product, there is little to worry about, but when it comes to more complex products like TVIX, investing should be left to only those who truly understand it. Think of these complicated funds as chainsaws; for most people, a chainsaw is an extremely dangerous tool that can cause severe damage for those who do not know how to use it. However, for those experienced enough, the chainsaw is incredibly effective and is a vital tool for many. If you are not experienced with volatility or any complex ETPs for that matter, you probably have no business investing in the first place.
Disclosure: No positions at time of writing.
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