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:
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.