VQTS: A Large Cap Investment That Protects Itself

Wednesday, July 1st, 2015 | Vance Harwood

In my opinion VQTS is the best exchange traded product for solving the essential conundrum of the stock market: how to run with the bulls without getting mauled by the bears.

The algorithms in VQTS are tuned to outperform the other hybrid volatility funds like Barclays’ VQT and VelocityShares’ SPXH during good times and to be competitive during the bad times.

We don’t have much trade data since UBS only introduced VQTS on December 3rd, 2014.  It stumbled in its first month of trading, but then recovered during the first half of 2015—but after 8 months it is only lagging SPX by 0.5% since its inception.

Hybrid-since-VQTS incept

 

All of the hybrid volatility funds dynamically allocate assets into the S&P 500 (SPX), VIX futures, and cash depending on market conditions.  VQTS is the first fund of this type that invests all of its assets into the S&P 500 when the market’s overall volatility is low.  This avoids the costs of hedging when the market is least likely to go down—during the long upward stretches of bull markets.  In comparison, two similar funds, Barclays’ VQT and PowerShares’ PHDG both have at least 2.5% of their assets allocated to long volatility—and that small amount significantly drags down their returns during bull markets.

The chart below compares the simulated performance of VQTS compared to SPX, VQT, and SPXH from early 2006.

3-Hybrid-anno

 

VQTS defines low volatility as being historical volatility less than 10% using the higher of two exponentially weighted moving averages on volatility.  Before shifting allocations VQTS requires that its historical volatility measure move by more than 10% from the target volatility used at its last rebalancing.  Once the target volatility climbs above 10% VQTS starts holding cash and volatility securities (2/3rds cash, 1/3rd volatility) in addition to the large cap S&P 500.  The table below shows the range of asset allocations as realized volatility increases.

 

VQTS Asset Allocations

Realized Volatility
(exponentially weighted)
Equity % Volatility % Cash %
0% to 10% 100% 0% 0%
10% to 20% 100% to 50% 0% to 16.7% 0% to 33.3%
20% to 30% 50% to 33.33% 16.7% to 22.22% 33.3% to 44.44%
30% to 40% 33.33% to 25% 22.22% to 25% 44.44% to 50%
40% to 50% 25% to 20% 25% to 26.67% 50% to 53.33%
50% to 60% 20% to 16.67% 26.67% to 27.78% 53.33% to 55.56%
60% to 70% 16.67% to 14.29% 27.78% to 28.57% 55.56% to 57.14%
70% to 80% 14.29% to 12.5% 28.57% to 29.17% 57.14% to 58.33%
80% to 90% 12.5% to 11.11% 29.17% to 29.63% 58.33% to 59.26%

In October 2008 the realized volatility as computed by VQTS’ algorithms peaked at 82%

 

When not fully allocated to equities VQTS takes a long or short position in VIX futures depending on the curvature of the futures’ term structure.  The term structure is the curve that’s formed if you plot VIX futures’ price vs time to expiration.  The decision to go long or short is determined by the comparison between the slope of the two nearest to expiration futures (1st and 2nd) and the slope of the 4th and 7th month futures.  I’ve marked up the chart below from vixcentral.com to illustrate the calculation.

TS-2Jun15l1+2+N-F

 

VQTS’ curvature calculation is similar, but not identical to the more familiar designations of contango and backwardation for futures’ term structures.  In general VQTS will go long volatility if the term structure is in backwardation (futures prices less than spot), and short volatility if the curve is in contango.  This approach would have worked well in the past, profiting from the fast rise of volatility as a crash / big correction develops, and then switching to be short volatility as volatility mean reverts.  The chart below shows the simulated performance of VQTS during the 2008/2009 crash.

VQTS-2008-crash

VQTS experienced around a 20% drawdown in the fall of 2008 before rallying to a year end gain of +13%.

Many strategies that backtest well on historical data do not perform well once they go live, but as I noted at the beginning of this post VQTS has already shown that it can approximate the S&P 500 during periods of low volatility—the condition the market is in 75% of the time.  VQTS’ drawdowns during crashes and corrections are likely to be significant, but VQTS’ strategy of going long volatility during panicky periods and short volatility during the recovery should continue to work well as a way to power through downturns.

UBS did think about Black Swan events when constructing this fund.  If VQTS was allocated to short volatility when a major disaster (e.g., terrorist attack) occurred the fund could experience very heavy losses.  If VQTS is down 60% or more intra-day from the previous close or the indicative value drops below $5 the fund is terminated.  This is called an acceleration.  The shareholder receives a payout that is equal to the liquidated assets of the fund—which may be higher or lower than the acceleration threshold levels.

VQTS is still a small fund with only $25 million in assets, so investors are hesitant to invest in it, but since the S&P 500 and VIX futures are its underlying securities its liquidity is excellent.  Bid/ask spreads have been reasonable—in the 6 to 7 cent range (0.3%).  Over time I expect its assets to grow into the $500 million range of its closest competitors, VQT and PHDG.

Everyone knows this bull market will end, the tough part is guessing when. With VQTS you can ride the bull and be prepared for the inevitable bad ending.

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How Does VXUP / VXDN’s Corrective Distribution Work?

Friday, June 26th, 2015 | Vance Harwood

It’s now clear that the VXUP/VXDN naysayers were right—the actual behavior of these funds is nowhere close to Accushares’ claim that “VXUP and VXDN are the first securities to offer direct “spot” exposure to the CBOE Volatility Index® (VIX).

Accushares has said nothing publicly about the poor behavior of the funds.  Their only response has been to move up the “go live” date of their Corrective Distribution process.

This is a desperation move.  Apparently not understanding what has happened to them they are rushing to use the last weapon at their disposal to fix their horrible tracking error (as high as 18%) relative to the VIX®.   This move will reduce their tracking problem for less than a day and add yet another complexity to these already complicated and broken funds.

Accushares’ Corrective Distribution (CD) is intended to reduce any ongoing differences between VXUP / VXDN’s Net Asset Value (NAV) and its market price.   I don’t know what specific scenarios they were targeted with this process, but I’m guessing they were worried about a slow, progressive creep in the market prices versus the NAV.

The CD is triggered if there are 3 consecutive days where the tracking error (difference between NAV and closing price) is 10% or greater.  To be a valid closing price the last trade must occur within 30 minutes of market close.   When the CD is triggered it doesn’t occur immediately, it’s scheduled to accompany the next monthly Regular Distribution or a Special Distribution if that occurs first.  A Special Distribution is triggered by a greater than 75% rise in the VIX compared to the reference VIX value established at the beginning of the monthly cycle.

Accushares did not expect frequent CDs to be required, in the prospectus they state: “The Sponsor expects that Corrective Distributions will be infrequent, and may never occur.”

It’s likely they will occur on a near monthly basis.    When there is a significant gap between the VIX’s value and VIX futures prices (which is most of the time) the VXUP/VXDN tracking error will be large.  See this post for a near real time accounting of these errors.

With a combined Regular Distribution and Corrective Distribution three things occur:

  1. The NAV of the higher valued fund is set to equal the NAV of the lower valued fund.
  2. A dividend is issued that compensates the holders of the higher valued fund for the drop in NAV value. The dividend is either in cash or an equal number of VXUP/DN shares with a net value equal to the cash dividend.
  3. Accushares issues a new complementary share to every shareholder. If you have VXUP you will get VXDN shares and vice versa.  This is the Corrective Distribution mechanism.

Since Accushares can’t create assets out of thin air they must compensate for the newly doubled number of shares outstanding by dropping their value by half (or do a 2:1 reverse stock split).

The effect of the Corrective Distribution is not obvious.  Working through an example is a good way to understand it.   Imagine that a CD has been triggered and that a Regular Distribution is about to occur.  You own 1000 shares of VXUP.  Let’s assume that the market price of VXUP is $27.5, the VXUP NAV is $25, and that the VXDN NAV is $22 at market close right before the distribution.

You would receive a dividend of $3/share due to the resetting of VXUP’s $25 NAV value down to VXDN’s ending cycle value of $22.   You would also receive 1000 shares of VXDN.  The new NAV value would be $22/2 = $11 / share because Accushares doubled the number of shares outstanding.

Before the CD the VXUP shares in your account were worth $27.5 X 1000 = $27.5K.   After the Regular / Corrective Distribution your account has:

Your net account value drops to $25K—your $2.5K premium over NAV has disappeared.   Any premium over the closing NAV value is wiped out by the CD.  The next day VXUP will likely trade at a multiple percentage points over NAV, but your VXDN shares will like be trading at a symmetrical discount from NAV, so the net value of your shares will remain at around $22K.   Accushares has essentially cashed out your account at the NAV price—no premium for you…

No diligent shareholder will willingly take this sort of loss, nor short seller pass up this opportunity for profit; the market will ensure the value of these funds converges near to NAV the eve of the distribution.

From an entertainment value perspective there will be a couple of things to watch once the CD mechanism becomes effective:

  1. Will traders attempt to prevent CD’s from happening? Imagine a scenario where some groups are trying to prevent a CD from happening by selling, or short selling shares, while others hoping to profit from a CD are buying shares hoping to keep the tracking error above 10%.
  2. How low will the tracking errors go before the CD date? Short sellers would tend to drive the tracking errors to zero, but the about to expire VIX futures values will be decaying rapidly at that point, so significant intra-day profits might still be available to arbitrageurs on the last days of trading.

The net effect of the CD will be to complicate and disrupt an already difficult situation.   It won’t fix the funds.  What Accushares should do is eliminate the Corrective Distribution.

Once broken is better than twice broken.

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Did Accushares Create a Product That is Linearizing the VIX Futures Term Structure?

Thursday, May 21st, 2015 | Vance Harwood

Eli Mintz, the publisher of vixcentral.com, has published an analysis that shows the arbitrage relationship between Accushares’ VXUP shares and VIX Futures.  It shows that investors can use VXUP shares to lock in a low risk position for any VIX Future expiration month.

What struck me about this analysis was the incentive to sell VIX futures that had a higher daily roll yield, regardless of what month expiration they are.    This would tend to linearize the term structure of VIX Futures, and with a whopping 3 days of VXUP trading under our belts, this seems to be happening.   Normally I would expect very heavy contango between the first and second month futures as we bump up against all time highs in the S&P, but instead the contango has decreased from last week.

TS-linear

This might just be an effect from the May futures expiration that occurred during this transition, but I think  contango normally stays pretty consistent across expiration boundaries.

It could be that Accushares has unintentionally created a VIX futures term structure linearizer…

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Tracking Information and Status Update on Accushares’ VXUP and VXDN

Wednesday, May 20th, 2015 | Vance Harwood

I’ve taken 20 minute delayed information to calculate tracking information and other items of interest using Google Sheets and Yahoo Finance’s on-line resources.   The day-end NAV values for these funds can be found here and here.

The last two lines in the table above show an experiment in progress.  It’s likely that the VXUP shares will track fairly close to the VIX futures that expires a couple days after VXUP / VXDN’s monthly cycle.  Currently I just multiply the current VIX future value by the Accurshares’ period multiplier factor (shown in the table below) and then apply the daily adjustment factor of 0.15% (only applies when starting VIX is <= 30) to the IV start value.

 

Status Update  16-June-2015

Nothing like a little real data to shake things up…  With 20 days of operational data to look at we can say some things about AccuShares’ VXUP and VXDN funds:

  1. These funds are NOT behaving the way described in the prospectus, in the marketing materials, and in the interviews provided by the supporters.  Tracking errors have matched what the detractors predicted–horrible.  Day end errors have been more than +-10% several days, and the funds are tracking VIX futures percentage movements rather than the VIX.  In contrast UVXY, an aggressive 2X short term volatility fund has a median tracking error of 0.08%.
  2. However, these funds are not dead in the water.
    • Volumes have been significant, especially VXUP.  One day had volume over 190,000 which is very impressive for a new fund.
    • Outstanding shares have quadrupled to 400K shares for each fund, giving a combined market cap of  $20 million after a week, again very impressive.
    • Bid / Ask spreads for both funds have been good, often dropping below 1%, very acceptable
    • Intraday Indicative Values (IV) are currently being published by Yahoo Finance under ^VXUP-IV and ^VXDN-IV
  3. Some implications of the numbers above:
    • The market makers for these funds were well prepared,  they were not surprised by the tracking error.  This is doubly impressive because of the novel nature of these funds.  VXUP / VXDN come in paired sets from Accushare, which I suspect broke a lot of software.
    • The Authorized Participants, the so called primary market for ETFs, were able to do share creation transactions with Accushares in spite of the wide tracking errors.  They needed to be able to short VXUP/VXDN shares at a combined price that was higher than the combined price of the NAV / IV prices that the funds were supposed to be trading close to.   The APs do risk free arbitrage operations for ETFs by shorting shares if they get too high above the IV values and doing share creations with the issuer (Accushares in this case) at the end of day to close out their short position at a profit.
    • I think both the market makers and the APs are using VIX futures to hedge their positions, otherwise I don’t see any way they would offer the small bid / ask spreads, or be willing to short VXUP/VXDN intraday and then wait for the end of day creation process.
  4. Puzzles and upcoming excitement
    • VXDN volume has been consistently lower than VXUP.  300K VXDN shares have been created since inception, and I’m pretty sure the total buy/sell volume for VXDN has been quite a bit less than that.  The market makers are apparently holding them, and I suspect are loaning them out for short selling.  Are the market makers willing to hold onto (“wear” in their vernacular) an indeterminate number of VXDN shares?
    • In the July 2015 cycle the Corrective Distribution (CD) process (see 11 Things You Should know about VXUP/VXDN) comes into play.  Its intent was to correct slowly accreting tracking errors (I’m guessing), but in actuality it looks like it will generate a truly minding bending challenge for the arbitrageurs that are trading these funds now.   If the the tracking error goes beyond +-10% for 3 consecutive days then a CD will be scheduled for the next distribution.  The CD will change the payout to the detriment of the arbitrageurs.   This creates a Prisoners Dilemma situation where everyone is punished if one trader gets greedy and pushes the fund past a 10% when there have been two consecutive closes with greater than 10%. For more see this post by Jay Wolberg on Trading Volatility.   Who knew how much entertainment value these funds would create!
    • The VIX term structure has been unusually linear since these funds came out.   In particular the price of the 2nd month future appears to have been brought down a bit.   This might cast a little light on what I think is a very murky arbitrage picture between VIX futures and the SPX options that theoretically provide their underpinnings.
  5. As near as I can tell AccuShares itself has gone dark except for accelerating the CD schedule by one month.   I think it’s highly likely that its filings for additional products like VXUP/VXDN will go on indefinite hold.    I’m hoping they will talk to some people that can help them understand what happened and chart a course forward that lets them be successful.  These funds are gathering assets, that is something a lot of startup ETFs have failed to do.

 

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Eleven Things You Should Know About AccuShares’ New VIX UP and VIX Down

Sunday, May 17th, 2015 | Vance Harwood

AccuShares’ new VX UP and VX Down funds started trading on May 19th.   There is a lot of interest in these Exchange Traded Products (ETPs) because they are the first funds to attempt a direct linkage to the CBOE’s VIX index.  An investable VIX has been the Holy Grail of volatility investment.

Unfortunately after a few weeks of actual trading things do not look promising.  The UP shares are trading way above (10% or more) where the fund’s indicative value (IV) is, and the Down shares are trading way below (10% or more) their IV.   It appears that the scenario pointed out this this comment to the SEC regarding the funds is playing out—arbitrage opportunities with VIX futures are dragging their values away from their intended operating model.   Right now their prices are behaving more like VIX Futures than the VIX index.   If this behavior continues the fund’s performance will not be even close to what the investor is led to expect from the marketing materials and the prospectus.

I have spent some time reviewing the prospectus.  As usual it is a confusing and frustrating exercise.  I don’t know what it is about prospectuses, they seem to give some information eight different times and if you are lucky other apparently critical things are only described once.

AccuShares states that these funds are intended only for sophisticated investors—I can second that.

The items below seemed important to me:

  1. The VIX Up and VIX Down Exchange Traded Notes (tickers VXUP & VXDN) trade in a monthly cycle. The cycle starts on the 16th calendar day of the month if it’s a business day, or the first business day after.
  2. At the end of the monthly cycle the fund with gains distributes a Regular Distribution of a cash dividend or stock grant of equal numbers of VXUP / VXDN shares of equivalent cash value to holders of record. Accushares believes that these distributions will be taxed as qualified dividends (pg 127).  Usual disclaimers about tax advice apply.
  3.  At the beginning of the monthly cycle the value of the two funds is set to the same value—the value of the lower of the two funds at the end of the previous cycle.
  4. The funds are designed to follow the percentage moves of the VIX (or the opposite), not the absolute value of the VIX. There will usually be a 0.15% daily adjustment that will be discussed later.   The theoretical values of the fund’s shares are called the Share Class or the IV values.  The fund’s initial Share Value was $25 per share.
  5. The fund issuer does not make any investments in volatility related securities. All assets are kept in cash or highly secure investments like treasuries or fully collateralized repos.   Earnings from these investments may be distributed as part of the regular monthly distributions.
  6. If the VIX index at the beginning of the period is less than or equal to 30 the Up fund’s value is decreased by 0.15% of the cycle’s beginning Share Class value every calendar day (cumulative 4.6% per month). This factor is derived from the typical losses that long volatility products like near month VIX futures or VXX experience in a typical month of trading (a month with no volatility spikes).   The Down shares are boosted by the same amount.  This tweak is intended to prevent disruptive trading by individuals or institutions using VXDN or VXUP to hedge other volatility investments.   Time will tell how well this works.
  7. The Regular Distributions at the end of the period are a bit tricky.  The winning fund will do a dividend distribution that will take its Share Class value down to the losing fund’s value.   The income from that dividend distribution will be partially offset by the capital loss from the winning shares’ value dropping all the way to the losing share’s value.  For example, at the beginning of a period let’s assume the VIX is at 40, and the VXDN/VXUP shares are worth $10, if the VIX goes up 10% during the period the value of the VXUP shares before the Regular Distribution would be  10+ 1/4* (44-40) = 11 and VXDN would be 10 – (1/4)*(44-40) =9.  The distribution for VXUP shares would be $2 per share (cash or share equivalents) and the new VXUP value after the distribution would be $9.   Net gain to the VXUP shareholders pre-tax would be +$2/share dividend – $1/share capital loss  = + $1 net, which is a 10% gain from the starting value.  Expect confused shareholders at this point.
  8. The funds do a Special Distribution if either experiences more than a 75% gain in the Share Class from the start of the monthly cycle. The maximum gain is capped at 90%.  This prevents the losing side from losing more than their initial investment.  The Special Distribution dividend for the winning fund is essentially the difference between the ending values of the opposing share classes on the Special Distribution date. The next trading day the Up and Down Class Share value will be set to the value of the losing side.  My rough simulation results below suggest that there would have been six such events since 2002, the last one (surprisingly) being on October 13th, 2014.

 

VXUP-Sim

 

  1. The Share Class value of the funds are published every 15 seconds during market hours as the indicative value (tickers ^VXDN-IV & ^VXUP-IV on Yahoo Finance).  In addition I have created a 20 minute delayed report that provides IV information along with tracking error and other tidbits.   If the funds are working well (which they aren’t) the IV prices should be close to, or within the market bid / ask spread.  The difference between the IV value and the traded value of the funds is called the tracking error.
  2. If the tracking error of day end trades vs IV values exceeds 10% for 3 consecutive days a Corrective Distribution (CD) will be scheduled to be implemented as part of the next Special or Regular Distribution (the first 60 days of operation are exempt).  A Corrective Distribution is a hard reset on the funds, where Accushares doubles the number of outstanding shares and distributes them in such a way to put every shareholder into a risk neutral position with equal numbers of Up and Down Shares.  Since the asset value of the fund won’t change at that point the NAV and Share Class value of the shares will have to drop by a factor of two (unless they do a simultaneous 2:1 reverse stock split).  The way the process works the premium / deficit due to tracking error will be removed from shareholder’s accounts at distribution time—it’s a very clever approach.   Since the market knows the CD is coming up the tracking error will drop to zero right before the regular distributions.  However people will get burned if a Special Distribution occurs once the monthly CD threshold is reached.  There’s no way to predict when a Special Distribution will occur.   Before introduction AccuShares did not think Corrective Distributions would be necessary, but it’s looking like they will be an every month thing after the startup period.   It also looks like they will only improve tracking errors for a few days.
  3. The best case scenario for AccuShares is not surprisingly heavy demand for both Up and Down shares. This would result in increasing assets under management and fee/investment income.  The worst case would be heavy buy demand for one share type and heavy selling on the other.  In this situation a key difference between VXUP and VXDN vs other Exchange Trade Products comes into play.   Accushares requires that APs bundle equal numbers of Up and Down shares when transacting share creations / redemptions.   This is unprecedented to my knowledge.  Every one of the other 1600+ ETPs has just a single fund involved in the creation / redemption process.  If there is a buy / sell imbalance between these two funds it may become unprofitable for the APs to do the arbitrage transactions that they typically execute that pull trading values closer to IV values.  If this occurs trading and IV values of the funds might become uncoupled from each other—which is a bad thing in the ETP world.

Many a volatility investor has cursed their screens when they have called a VIX move correctly and see their volatility positions barely move, or even go in the opposite direction.  If AccuShares is successful with VXUP and VXDN I expect a flood of money will come their way.




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