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.



How To Get Silverlight Working Again on Chrome

Friday, April 24th, 2015 | Vance Harwood

In early April I attempted to logon to Fidelity’s Active Trader Pro using my Chrome browser and I was greeted with:

SilverLight

 

 

 

I was pretty sure Silverlight was installed on my system, but I dutifully reinstalled it—and was informed that it was already installed.  Suspecting a browser issue I fired up Internet Explorer where Active Trader Pro ran correctly.

Investigation revealed that Google has decided to obsolete the old Netscape Plugin Application Interface (NPAPI) technology, which Silverlight relies on.   According to Google this change:

 …will improve Chrome’s security, speed, and stability as well as reduce complexity in the code base.

In April Google blocked all Chrome plugins using NPAPI by default but provided an override for advanced users.  That override is scheduled to go away in September 2015.

I used Fidelity’s chat line for recommendations on how to address this.   Their opening bid was for me to switch to Internet Explorer or Firefox.  I declined and asked if there was a workaround for Chrome.   The first step was to start up my Chrome browser and type “chrome://flags/” (no quotes) in the address bar and enter.   The resultant page:

chrome-flags

Next I was instructed to search for NPAPI on this page; you can use the Search function (Ctrl +F) to do this.   The “Enable NPAPI” item was towards the bottom of the 1st page.   I clicked the enable link.

Next I was instructed to type “chrome://plugins” (no quotes) in the address bar and enter.   My plugin page looked like this:

Chrome-plugins

On my system Silverlight showed up as the 3rd plug-in in the list.  I was instructed to click the enable link and check the “Always allowed to run” box.

At this point Active Trade Pro on Chrome worked.   The Fidelity representative warned that they have seen some problems with streaming information with this workaround, so be aware that streaming quotes might not be valid.

Google’s move puts Fidelity and others like them that use Silverlight in a difficult position—either force approximately 25% of their users to change browsers (Chrome’s current market share), or rewrite their code to not use Silverlake technology (e.g., switch to HTML5).  And they only have until September to get this done…

I’m with Google on this one. I’ve been involved with large software projects where old technologies have become an increasing source of complexity and performance issues.  It’s painful to move forward, but in the long run the user really benefits from obsoleting the old code.



How Does UVXY Work?

Wednesday, March 18th, 2015 | Vance Harwood

Exchange Trade Fund UVXY and its Exchange Traded Note cousin TVIX are 2X leveraged funds that track short term volatility.  To have a good understanding of UVXY (full name:  Ultra VIX Short-Term Futures ETF) you need to know how it trades, how its value is established, what it tracks, and how ProShares makes money running it.

 

How does UVXY trade? 

  • For the most part UVXY trades like a stock. It can be bought, sold, or sold short anytime the market is open, including pre-market and after-market time periods.  With an average daily volume of 21 million shares its liquidity is excellent and bid/ask spreads are a penny.
  • It has an active set of options available, with seven weeks’ worth of Weeklys and close to the money strikes every 0.5 points.
  • Like a stock, UVXY’s shares can be split or reverse split. If fact, UVXY reverse split 4 times in its first three years of existence—which may be a record.  The last reverse split was a 4:1 and I’m predicting the next one will be around May-June 2015 and will be a 4:1 ratio also.  See this post for more details.
  • UVXY can be traded in most IRAs / Roth IRAs, although your broker will likely require you to electronically sign a waiver that documents the various risks with this security. Shorting of any security is not allowed in an IRA.

 

How is UVXY’s value established?

  • Unlike stocks, owning UVXY does not give you a share of a corporation.  There are no sales, no quarterly reports, no profit/loss, no PE ratio, and no prospect of ever getting dividends.  Forget about doing fundamental style analysis on UVXY. While you’re at it forget about technical style analysis too, the price of UVXY is not driven by supply and demand—it’s a small tail on the medium sized VIX futures dog, which itself is dominated by SPX options (notional value > $100 billion).
  • According to its prospectus the value of UVXY is closely tied to twice the daily return of the S&P VIX Short-Term Futurestm  This index manages a hypothetical portfolio of the two nearest to expiration VIX futures contracts.  Every day the index specifies a new mix of VIX futures in that portfolio.  For more information on how the index itself works see this post or the UVXY prospectus.
  • The index is maintained by S&P Dow Jones Indices. The theoretical value of UVXY if it were perfectly tracking 2X the daily returns of the short term index is published every 15 seconds as the “intraday indicative” (IV) value.  Yahoo Finance publishes this quote using the ^UVXY-IV ticker.
  • Wholesalers called “Authorized Participants” (APs) will at times intervene in the market if the trading value of UVXY diverges too much from the IV value.  If UVXY is trading enough below the IV value they start buying large blocks of UVXY—which tends to drive the price up, and if it’s trading above they will short UVXY.  The APs have an agreement with ProShares that allows them to do these restorative maneuvers at a profit, so they are highly motivated to keep UVXY’s tracking in good shape.

 

What does UVXY track?

  • Ideally UVXY would exactly track the CBOE’s VIX® index—the market’s de facto volatility indicator.  However since there are no investments available that directly track the VIX ProShares chose to track the next best choice: VIX futures.
  • VIX Futures are not as volatile as the VIX itself; solutions (e.g., like VXX) that hold unleveraged positions in VIX futures only move about 55% as much as the VIX. This shortfall leaves volatility junkies clamoring for more—hence the 2X leveraged UVXY and TVIX.
  • ProShares achieves the 2X daily return by taking advantage of the fact that VIX futures only require a small percentage (e.g. typically less than 25%) of their face value be deposited as margin to purchase the contract.  By doubling up the number of contracts they own they can double the returns.  To keep this leverage near a constant 2X they have to adjust the number of futures contracts held by the fund at the end of every trading day.  This adjustment is essentially a compounding process.
  • If you want to understand how 2X leveraged funds work in detail you should read this post, but in brief you should know that the 2X leverage only applies to daily percentage returns, not longer term returns. Longer term results depend on the volatility of the market and general trends.  In UVXY’s case these factors usually (but not always) conspire to dramatically drag down its price when held for more than a few days.
  • The leverage process isn’t the only drag on UVXY’s price. The VIX futures used as the underlying carry their own set of problems. The worst being horrific value decay over time.  Most days both sets of VIX futures that UVXY tracks drift lower relative to the VIX—dragging down UVXY’s underling non-leveraged index at the average rate of 7.5% per month (60% per year).  This drag is called roll or contango loss.
  • The combination of losses due to the 2X structure and contango losses add up to typical UVXY losses of 12.5% per month (80% per year). This is not a buy and hold investment.
  • On the other hand, UVXY does a good job of matching the short term percentage moves of the VIX. The chart below shows historical correlations with the linear best-fit approximation showing UVXY’s moves to be about 92% of the VIX’s.    The data from before UVXY’s inception on October 3, 2011 comes from my simulation of UVXY based on the underlying VIX futures.

UVXY-VIX-scatter

 

  • Most people buy UVXY as a contrarian investment, expecting it to go up when the equities market goes down.  It does a respectable job of this with UVXY’s percentage moves averaging -5.96 times the S&P 500’s percentage move. However 16% of the time UVXY has moved in the same direction as the S&P 500.  So please don’t say that UVXY is broken when it doesn’t happen to move the way you expect.
  • The distribution of UVXY % moves relative to the S&P 500 is shown below:

UVXY-movesJPG

  • With erratic S&P 500 tracking and heavy price erosion over time, owning UVXY is usually a poor investment. Unless your timing is especially good you will lose money.

 

How does ProShares make money on UVXY?

  • As an Exchange Trade Fund (ETF) UVXY must explicitly hold the appropriate securities or swaps matching the index it tracks. ProShares does a very nice job of providing visibility into those positions.  The “Daily Holdings” tab of their website shows how many VIX futures contracts are being held.  Because of the 2X nature of the fund the face value of the VIX futures contracts will be very close to twice the net “Other asset / cash” value of the fund.

UVXY-Daily-Holdings

  • ProShares collects a daily investor fee on UVXY’s assets—on an annualized basis it’s 0.95% per year.  With current assets of $700 million this fee generates around $6 million per year.  That should enough to cover ProShares UVXY costs and be profitable, however I suspect the ProShares’ business model includes revenue from more than just the investor fee.
  • One clue on the ProShares’ business model might be contained in following sentence from UVXY prospectus (page 18):
    “A portion of each VIX Fund’s assets may be held in cash and/or U.S. Treasury securities, agency securities, or other high credit quality short-term fixed-income or similar securities (such as shares of money market funds and collateralized repurchase agreements).”  Agency securities are things like Fannie Mae bonds.  The collateralized repurchase agreements category strikes me a place where ProShares might be getting significantly better than money market rates.  With UVXY currently able to invest around $350 million this could be a significant income stream.
  • According to ETF.com’s ETF Fund Flows tool, UVXY’s net inflows have been around $1.8 billion since its inception in 2011.  It’s currently worth $700 million, so ProShares has facilitated the destruction of about a billion dollars of customer’s money—so far.  I’m confident the overall destruction trend will continue.
  • UVXY has escaped the negative publicity that Barclays’ VXX and VelocityShares’ TVIX funds have generated, but as it continues to grow in size, and continues to destroy shareholder value at eye watering rates it’s probably a matter of time before UVXY starts getting vilified on its own merits or lack there-of.

 

UVXY is like a loaded gun, effective when used at the right time, but dangerous if you leave it lying around.

UVXY chart

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How Does VXX’s Daily Roll Work?

Monday, January 19th, 2015 | Vance Harwood

All volatility Exchange Traded Products (ETPs) use indexes that track a mix of two or more months of the CBOE’s VIX Futures.  Calculating this mix is not trivial and has resulted in a lot of bleary eyes—including my own.  My intent with this post is to help you understand, and if you desire accurately compute the key indexes used in VXX and other short term volatility funds using Excel or similar tools.

Why do we need a roll anyway?

If we could directly buy the CBOE’s VIX® index none of this would be necessary.  Unfortunately no one has figured out a cost effective approach so we are forced to use the next best thing—VIX Futures.  Like options, VIX futures have fixed expiration dates so volatility indexes need a process of rotating their inventory of futures in order to have consistent exposure to volatility.   This rotation process is evident in the open interest chart below—the next to expire futures being closed out and the next month of futures being opened.

OI-VIX-Futures


Indexes and Funds—are different things

Before we dive into the details of how this rotation is dealt with, I’d like to address one source of confusion.  ETP’s are not obligated to follow the approach detailed in the indexes.  They are allowed to use other approaches (e.g., over-the-counter swaps) in their efforts to track their indexes.  When ETPs are working properly, their prices closely track the index they specify in their prospectus minus their fees that are deducted on a daily basis.

Because indexes are theoretical constructs they can ignore some practical realities.  For example they implicitly assume fractional VIX futures contracts exist and that the next day’s position can be put in place at market close—even though calculating that position requires market close information.  I’m sure these issues cause headaches for the fund managers, but to their credit the funds usually closely track their index.

The Index Calculation

 The details for the index (ticker SPVXSTR) that VXX tracks are detailed in VXX’s prospectus, pages PS-21 through PS-22. The math is general enough that it covers both the short term index that VXX uses and the midterm index VXZ uses—which adds to its complexity.  The equations use Sigma notation, which probably makes it challenging for people that haven’t studied college level mathematics.   I will present the math below using high school level algebra.

Except for interest calculations all references to days are trading days, excluding market holidays and weekends.

The volatility indexes used by short term volatility ETPs (list of all USA volatility ETPs) utilize the same roll algorithm—at the end of each trading day they systematically reduce the portion of the overall portfolio allocated to the nearest to expiration contracts (which I call M1) and increase the number of the next month’s contracts (M2).

The mix percentages are set by the number of trading days remaining on the M1 contract and the total number of days it’s the next to expire contract (varies between 16 and 25 days).  So if there are 10 days before expiration of the M1 contract out of a total of 21 the mix ratio for M1 will be 10/21 and 11/21 for M2.  At close on the Tuesday before the Wednesday morning M1 expiration there’s no mix because 100% of the portfolio is invested in M2 contracts.

It’s important to understand that the mix is managed as a portfolio dollar value, not by the number of futures contracts.   For example, assume the value at market close of a VIX futures portfolio was $2,020,000, and it was composed of 75 M1 contracts valued at 12 and 80 M2 contracts at 14 (VIX futures contracts have a notional value of $1K times the trading value).   To shift that portfolio to a 9/21 mix for M1 and 12/21 for M2 you should take the entire value of the portfolio and multiply it by 9/21 to get the new dollar allocation for M1, $865,714  (72.14 contracts) and 12/21 times the entire portfolio value to get the dollar allocation for M2,  $1,154,286 (82.45 contracts).

Value weighting gives the index a consistent volatility horizon (e.g., 30 calendar days)—otherwise higher valued futures would be disproportionately weighted.

The next section is for people that want to compute the index themselves.  Yes, there are people that do that.   If you are interested in the supposed “buy high, sell low” theory of roll loss you should check out the “Contango Losses” topic at the bottom of this post.

 

The Variables

 Lower case “t” stands for the current trading day, “t-1” stands for the previous trading day.

The index level for today ( IndexTRt ) is equal to yesterday’s index (IndexTRt-1) multiplied by a one plus a complex ratio plus the Treasury Bill Return TBRt.  The index creators arbitrarily set the starting value of the index to be 100,000 on December 20th, 2005.

 The number of trading days remaining on the M1 contract is designated by “dr” and the total number of trading days on the M1 contract is “dt.”

M1 and M2 are the daily mark-to market settlement values, not the close values of the VIX futures.  The CBOE provides historical data on VIX futures back to 2004 here.

 

The Equations

When dr is not equal to dt: 

Index-normal

 

 

 

When dr = dt (the day the previous M1 expires):

Index-exp

 

 

 

Yes, this equation could be simplified, but then it wouldn’t fit as nicely into the equation below which uses a little logic to combine both cases:

Index-combined

 

 

The equation assumes that the entire index value is invested in treasury bills.

 

Contango Losses

  • An interesting special case occurs when you assume that the M1 and M2 prices are completely stable and in a contango term structure for multiple days—for example, M1 at 17 and M2 at 18. In that situation the equation simplifies to:

Index-contango

 

 

  • This special case illustrates that there is no erosion of the index value just because it’s selling lower price futures and buying higher priced futures—in fact it goes up because of T-bill interest. It’s the equivalent of exchanging two nickels for a dime—no money is lost.  For more on this see: The Cost of Contango—It’s Not the Daily Roll.

 For more information:

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Near Real Time Graphical VIX Term Structure

Friday, January 16th, 2015 | Vance Harwood

Anyone that follows volatility closely knows that short term views on volatility are much more dynamic than longer term. For example, if the market is moving from a dip into a “V” style recovery the CBOE’s 9 day expectation of volatility VXST, will drop much more than the 30 day VIX.

A chart showing volatility expectations vs time is called a volatility term structure.  The updating chart below uses indexes published by the CBOE to provide up to 6 different points on the current VIX term structure.  The green dots show the numbers published by the CBOE.

 

The older style VIX calculation (VIXMO) is shown as the black vertical bar and the top of the purple outline around it shows the VIX value.

All VIX style volatility calculations are annualized—they indicate how much the market would be expected to vary in a year if the volatility stayed at that level.  So for example if the volatility number is 15 then the model predicts that the market will stay between +-15% of the current value in the next year with a 68% probability.

The annualization process assumes that volatility drops off with the square root of time. This is a good assumption, however there is a question of what sort of time should you use.  For example the CBOE uses calendar time but I think there is a good case for using the actual amount that the market will be open instead—not counting evenings, weekends and holidays.  The triangles shown on the graph show the CBOE index values annualized with market time instead of calendar time.   Although the two calculations often agree sometimes there are significant deviations.

 

Additional Resources:

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