When You Think Your Exchange Traded Fund is Broken…

Sunday, March 17th, 2013 | Vance Harwood
 

When you thing your ETF/ETN is broken...
Frequently I see people complaining that their Exchange Traded Fund (ETF) or Exchange Traded Note (ETN) is broken. Occasionally they’re right, but most of the time they’re not.  Before complaining, here are some things to look at:

  1. Are you looking at the right index?
    • All Exchange Traded Products (ETPs) track an index, which is identified in their prospectus, and in the fund’s fact sheet.   Don’t assume what the index is.  For example, the index that VXX tracks is not the CBOE’s VIX® , and UVXY the 2X volatility fund is not designed to track 2X the VIX.
    • None of the volatility funds track the VIX, they all use other indexes, because the VIX itself is not investable.  Some funds (e.g., UVXY, CVOL) do a semi-decent job of tracking the VIX in the short term, but nobody does a good job in the medium to long run.  In fact it’s a killing field.
    • Investigate the index once you’ve determined what it is.  It’s often not easy; sometimes even getting quotes on indexes is hard.  But similar to the hunter’s credo of eating what they kill, investors should understand what they trade.
  2. Is the fund leveraged/geared (e.g., 2X, 3X), or an inverse fund?
    • Leveraged or inverse funds typically do a good job of delivering their target performance on a daily basis, but usually fall far short with longer time frames.  The reason is compounding error, or path dependency.  It erodes the value of these funds in choppy markets.
    • For example if a non-leveraged fund (e.g., SPY) goes up 10% one day and down 9.09% the next it ends up even.   However the 2X fund (SSO) and the inverse fund (SH) both end up down 1.8%
      • 2X Fund: (10*(2*10%)=12, 12*(2*-9.09%) = 9.82
      • -1X Fund: (10* (-10%) =9,  9 *(+9.09%) = 9.82
  3. What are the timestamps of the quotes you are looking at?
    • Unless your fund is very active the quote you’re using might be older than you think.  For example the fund’s closing value might reflect a trade that happened hours before market close.  If you look at an intra-day chart of your fund including volume you should be able to see when the trades occurred and the quotes updated.  Typically the intraday indicative value (“IV”) quote is a more accurate way of getting the actual fund value. It’s updated every 15 seconds during market hours.
    • The IV quote tickers are not standardized.  Yahoo finance uses a “^” prefix and a “_IV” suffix to get the IV value (e.g., ^VXX_IV).  For more on IV quote symbols see Trading ETFs Without Getting Fleeced.
  4. Are the markets you’re comparing closing at the same time?
    • VIX futures markets at the CBOE Futures exchange trade for 15 minutes after the equities markets close.   The volatility ETPs are based on volatility indexes that are based on futures settlement values.  Eli from VIX Central points out that these settlement values can come out well after 4:15.  The final IV update for the day appears to reflect these late settlements—giving us the real closing value for the volatility funds.
  5. Is the trading value of the funds diverging significantly from its index or IV value?
    • If this is the case, your fund might be broken, but before we pursue that there are a couple thing to check:
      • Are the markets for the underlying assets closed (e.g., Asian or European stocks)?  If so those indexes can’t update so some divergence during USA trading hours should be expected.
      • Are the securities for the underlying assets illiquid or rarely traded (e.g., high yield corporate bonds)?  If so the trading value might reflect the market’s estimation of what those assets are worth, rather than the last trade, or published bid/ask quotations.

If you’ve checked through all the items above and things still look wrong your fund may indeed be broken.  Historically the only pathology for ETF/ETNs is to have their share creation process halted or somehow limited.  Some of the stated reasons for doing this are:

  1. Market closures (e.g., the Egyptian stock market closed for 2 months in 2011: EGPT, )
  2. Regulatory hurdles, where permission to issue new shares is delayed UNG, UNL, DNO
  3. Issuer “internal limits on the size of ETNs”, TVIX
  4. Commodity  position limits, where the exchanges won’t allow the funds to accumulate more contracts UNG
  5. Self-imposed market cap limits AMJ

In all these cases the share redemption process has been left intact.  In practice if share creation is stopped and redemption is working the ETP’s price can rise higher than the index, but not drop significantly lower than the index.   Both UNG and TVIX were expensive object lessons for the people that didn’t understand this.

NYSE EURONEXT has a good webpage that lists all the funds that currently have suspended or put limits on share creation.

Credit Suisse’s TVIX has restarted limited share creation processes, but its requirements are so expensive the market makers still allow the fund to climb as much as 15% higher than its IV value—I consider that broken.

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TVIX Gets a New Lease on Life

Friday, February 22nd, 2013 | Vance Harwood
 

On Friday, December 14th, Credit Suisse announced a 10:1 reverse split of TVIX, effective the 21st.  I had pretty much given up on TVIX because its price had slid way past the logical reverse split point and has traded below $1 for the last 16 trading days.  However instead of fading to black TVIX is now back into a reasonable trading range.

In February 2012 Credit Suisse got nervous about the rapid growth and size of TVIX, and temporarily pulled the plug on new share creation. Market makers need the share creation process to keep the price of Exchange Traded Products (ETPs) from rising too far above their Net Asset Value (NAV).  Typically if the ETP’s price floats too high they short the security with the knowledge that the ETP issuer is usually happy to issue new shares at the NAV price they can buy to cover the short—guaranteeing the market maker a risk-free profit. The selling naturally drives the price of the security down.

Credit Suisse restarted partial share creations a month later, but in the interim the NAV of TVIX had plummeted 56%—while the market price of TVIX only drifted down 15%. The resultant correction vaporized $277 million of TVIX value in a day. Subsequent tracking still wasn’t great—Credit Suisse’s partial solution was expensive for the market makers and only profitable for them to short the ETP if it was 5% to 15% above the NAV price—better but still a horrible tracking percentage.

Apparently Credit Suisse had been working on the share creation problem. The TVIX prospectus was revised in early November and starting November 23rd, TVIX’s tracking improved considerably.  The chart below shows its tracking error alongside of ProShares’ UVXY— its closest competitor.

TVIX and UVXY % Tracking to their NAV

TVIX and UVXY % Tracking to their NAV

 

When TVIX’s tracking error dropped suddenly on November 23rd it appears that it spooked some investors into dumping their UVXY—messing up its tracking for an hour or so until its market makers pulled it back into line.

Unfortunately this improved tracking was a short term thing.   A week or two after the split  TVIX’s tracking error returned to the 5% to 7% range.  While not a killer, I’m hard pressed to see any advantages of TVIX over ProShares’ UVXY, its well behaved ETF based equivalent.

Year to date in 2012 TVIX is down an astonishing 97%, but it was even a worse year than normal for 2X leveraged volatility funds. Next year I project a 90% loss, so TVIX might not require reverse splitting again until around December 2013.

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TVIX’s Fate—Fade to Black?

Saturday, December 29th, 2012 | Vance Harwood
 

Update:  Credit Suisse did do a 10:1 reverse split of TVIX effective December 21st, 2012 and it appears they might have made changes to improve its NAV tracking.   For more information see TVIX Gets a New Lease on Life.

*****************************************

Ever since TVIX dropped below $10 in late March 2012 I had been expecting Credit Suisse to announce a reverse split, but by July there was no split and with the price at $4 it started to look likely that we were witnessing an exit strategy.   Does Credit Suisse want TVIX dead, and will it let contango be the killer?

Things have not been well with TVIX since Feb 21st, when Credit Suisse stopped the share creation process.   In late March a modified creation process was put in place, but that has only been partially successful—the TVIX price has often been floating 5% to 10% above its Indicative Value (IV).  This is much better than the 90% premium we saw in early March, but it’s still not good.  The IV tracks the underlying index that exchanged traded products (ETP) are designed to follow.  TVIX’s competitor, ProShares UVXY for example usually trades within 1% of its IV value.

When Credit Suisse pulled the plug on share creations they cited “internal limits” as the reason.   The chart below from the Index Universe ETF Fund Flow Tool shows TVIX’s inflow/outflows in 2012.

 

TVIX’s 2012 Fund Flows

In January and February TVIX had net inflows of $642 million dollars as its volume increased to surpass Barclays’ VXX as the volume leader in volatility ETPs.  Normally this would be great news, but with a 2X leveraged fund like TVIX there’s a not so pleasant obligation that comes with growth.  In order for a 2X leveraged fund to maintain its leverage factor it needs to adjust its market exposure every day.  If the daily value of the underlying index (SPVXSTR in this case) goes up 10%, then Credit Suisse must increase its investment by 20% of the fund’s assets under management (AUM) that same day. See Under the Hood of a Leveraged ETP for an example of how this works with leveraged and inverse funds.

Volatility indexes tend to be…well, volatile.  In the last six years SPVXSTR experienced daily spikes of: 24%, 21%, 20%, 19%, and three of 14%.   If there was another worst case jump of 24% in the SPVXSTR index (27-Feb-07) Credit Suisse would need to invest an additional 48% of the current assets of the fund to maintain the 2X leverage factor.  With AUM of $690 million (22-Feb-2012 actual) this would require a $330 million incremental investment at market close to rebalance the fund.  And of course, volatility begets volatility so the next day’s jump could be similar or worse.

With TVIX’s AUM nearing $700 million, and growing rapidly it’s not shocking that Credit Suisse pulled the plug on creations to put a lid on this exposure.

Some people have speculated that Credit Suisse balked because traders were front running the big end of day VIX Futures buy/sells associated with daily rolls and rebalancing.  I don’t think this is a factor—Credit Suisse doesn’t care what SPXVSTR closes at, as long as their funds track it they’re happy.

I think the underlying problem that spooked Credit Suisse was the credit risk of the swaps that are used to hedge their positions.   My understanding is that volatility ETN vendors like Credit Suisse typically don’t directly manage the nuts and bolts of index hedging, instead they outsource that function to 3rd parties via volatility or variance swaps.

That’s ok until a 3rd party defaults on a swap—then the heat is on Credit Suisse.  Since ETNs are senior notes Credit Suisse is obligated to honor them—or go bankrupt.   I don’t see a mechanism for passing those losses directly to the TVIX shareholders via the share price.

When faced with risks of this magnitude Credit Suisse wanted lower risk swaps—which are naturally more expensive.   Rather than absorb these costs internally, which would likely have rendered TVIX unprofitable, they opted to push the problem onto the market makers.

So when Credit Suisse resumed share creation they added this language regarding hedging instruments, which includes swaps, to their prospectus:

 “…will be on terms acceptable to Credit Suisse, including the counterparty meeting Credit Suisse’s creditworthiness requirements, margin requirements, minimum size and duration requirements and such other terms as Credit Suisse deems appropriate in its sole discretion.”

Apparently these terms are expensive enough that market makers can only profitably create shares if TVIX is trading 5% to 10% above its IV price.  This is a bad situation because TVIX can fluctuate between its IV value and 10% above for no reason.

So how does ProShares’ UVXY, an Exchange Traded Fund (ETF) which offers the same 2X leverage on short term volatility deal with credit risk?   ETFs don’t do internal hedging, they always require the market makers to provide the underlying securities/hedges in exchange for new shares.   Swap defaults are a possibility for ETFs too, but if it occurs it will be reflected in the share price.  To reduce this risk ProShares requires daily marked to market collateral and only works with large, well-capitalized, well established financial institutions like Deutsche Bank, UBS, and Goldman Sachs.

But the bottom line is that the shareholder takes the default risk, not the ETF.  For more on ETF/ETN credit risk see this post.

If Credit Suisse has not figured out how to fix TVIX so that it tracks its index acceptably, they might want it to go away.   They can do this by doing nothing.

Without a reverse stock split TVIX will be eroded down towards zero by contango.  If there aren’t any significant volatility spikes TVIX tends to decay around 90% per year, so it will probably take until December before it drops below $1.  My understanding is that because TVIX is based on futures  it may not be subject to the NYSE delisting rules, but at sub dollar prices it is not a mainstream product.

Fade to black.

 

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How to Vaporize $277 Million in Market Capitalization

Sunday, December 16th, 2012 | Vance Harwood
 

Wednesday night, March 23, 2012, I was wondering if there was a graceful way for Credit Suisse to restore TVIX to working order and get its share creation process working again.   The Wednesday close was $14.43, roughly 2X the $7.62 indicative value (IV) giving a market capitalization of $587 Million.   The correct market cap, based on the indicative value was $310 Million.  Somehow $277 million needed to go away.

Thursday that problem departed—in a very ungraceful fashion.  Apparently the word got out early, because by Thursday evening when Credit Suisse announced reopening of share creation on a limited basis, TVIX had plunged 29% to $10.2

It’s tough to keep a quarter billion dollar secret.

TVIX was trading at $9.00 in the Thursday after-market—still 15% away from its closing indicative value of $7.83.  Most if not all of that difference will go away Friday.

There was a lot of finger pointing going on Thursday, but what surprised me the most was the level of ignorance displayed by some of the general media (e.g., CNBC, Forbes).  I don’t expect them to be experts on this corner of esoterica, but I do expect them to know that they didn’t understand this field and take the time to consult an expert.   It’s not like Bill Luby is an unknown personality in the volatility arena.

Regarding Credit Suisse’s reopening, the first step, starting as soon as Friday, March 23rd will be to make TVIX shares available for lending—this will enable short sellers to drive down any remaining premium of  TVIX over its IV.

As early as the 28th, share creation may resume, but Credit Suisse can require market makers to sell them specified hedging instruments as part of the transaction.    This takes them close to the Exchange Traded Fund (ETF) model, where this is the standard process (e.g., UVXY).    TVIX is an Exchange Traded Note (ETN), which normally does share creation on a cash basis, but adding this requirement allows Credit Suisse to at least partially protect themselves if the underlying hedges (e.g.. VIX futures, variance swaps) get pricey.

To exactly hedge these VIX future based volatility funds all ETN and ETF providers (complete list) would need to roll their mix of futures on a daily basis.    In addition most leveraged and inverse funds, with the exception of Barclays‘ products,  may need to rebalance their hedges as often as daily to setup for their daily percentage performance goal.   In volatile times, for a ETN of TVIX’s size,  this rebalancing can involve buying or selling hundreds of millions dollars worth of hedging instruments (example).   They can’t put the market makers on the hook for that, but if the market makers can get the hedging instruments at reasonable prices, Credit Suisse should be able to also.

In the interests of accuracy I should point out that neither the volatility ETNs or ETFs are obligated to do their daily rolls or rebalancing in a certain way, or at all, based on what they say in their SEC documents.  It is up to them how they manage this, and they aren’t obligated to reveal their hedging or risk management processes.

The Credit Suisse press release is silent regarding the “internal limits” that caused this mess in the first place.  I’m assuming they won’t pull the plug again just based on fund size.  Their additional restrictions give them an objective way to halt share creations if hedging costs go out of line, and an ever present possibility of creation resuming should help keep the share price close to the indicative value.

Volatility as an asset class is showing some growing pains.   People have flipped out because the futures rolling/hedging needs of the volatility ETN / ETFs now dominate the VIX futures market, and a lot of people have learned the hard way that a gap between the market value of an ETF / ETN and the indicative value can vaporize in an instant.  But it doesn’t look like growth has changed the underlying structure of the market—the volatility marketplace does not show any objective signs of distortion.  Sure the VIX futures term structure is in major contango, but most people feel the market is overdue for a correction, so that is not surprising.

Feel free to place your bets if you think those are distorted prices.

 

 

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So What if Volatility ETN/ETFs are Growing—Where are the Problems?

Thursday, March 8th, 2012 | Vance Harwood
 

It’s clear that the volatility ETN/ETFs have begun to dominate the VIX Futures market.  What isn’t clear is whether it matters.  Volatility isn’t  a commodity like gold or corn that is physically limited, so future position limits don’t seem applicable.  When the price of  VIX futures is attractive, more can be created—and appropriate hedges put in place.  But are these hedges distorting the overall market?

Some people have pointed at the current state of the VIX future term structure relative to the VIX as evidence of market distortion.  The long dated futures (e.g., 7 months out) have recently been over 11 points higher than the VIX index.    Although they ultimately expire close to the VIX index (VRO settlement), VIX futures tend to have a mind of their own.   When the market is not panicky VIX Futures are normally priced higher than the VIX index, and the longer the term of the futures (expiriation date further out), the higher the premium.   Think of it as insurance, the longer the term of the insurance, the more expensive it will be.  The chart below shows the VIX index price at the far left, with the VIX futures prices for months 1 through 7 shown left to right for several dates—two times of high fear (2008 crash, August 2011), and two times when the VIX has been low compared to the futures (November 2010, and March 2, 2012)

VIX + VIX Future Term Structure

 

The recent term structure doesn’t appear to be totally out of whack with the comparable period in November 2010.

The chart below shows the relationship between the VIX index and the 7th month VIX future (M7), with the green M7-VIX  line showing the difference between the two.

 

VIX vs M7

Compared to the 40 point negative difference in 2008 the current VIX vs M7 relationship looks pretty pedestrian.

The other, much noisier discussion has been on the volume impact of the volatility ETN/ETFs  on the VIX futures market .   The assets that the funds hold are growing rapidly and their required daily activities in the VIX futures markets are 90% plus of the market.   Specific concerns:

  • Is it a problem that Volatility ETN/ETFs now do most of the trading on the VIX Futures Market?
  • Volatility ETN/ETFs have known trading patterns.  Their prices are based on daily future rolls (selling nearer months, and buying further out months) in order to preserve a constant time maturity.   Can this knowledge be exploited to game the market against the ETN/ETF providers?
  • Will the overall growth of the VIX futures market cause problems?
The analysts over at IndexUniverse did a nice job of piecing together a rough estimate of the ETN/ETFs impact on the market, but the CBOE posts historic VIX futures data (price, volume, open interest) from the beginning of tracing in 2004 and I have a spreadsheet that enables me to analyze that data.   The chart below shows open interest on first (M1) and second month (M2) VIX futures during the first half of 2011.

Short Term Volatility Open Interest

The red M1 open interest shows a big step up once a month when the previous M2 futures become the M1s at futures expiration.  After the jump up the open interest on the M1s drops as the ETN/ETFs sell them and buy the M2s.  You can see the green M2 line increasing and the M1 dropping.  The blue line above is the combined open interest of the two—giving a reasonable measure of the overall short term VIX futures open interest.   Notice that the open interest for the M1 and M2 contracts doesn’t  drop below 20,000 contracts.  This number has been relatively consistent since Mid 2010, and represents the institutional and retail business that isn’t locked into the daily roll cycle.   In the first half of 2010 these 40K contracts were about 40% of the overall 100K in short term open interest.

 

 Barclays’ introduced the first Volatility ETNs, the short term VXX and the medium term VXZ in January 2009.  This next chart shows short term VIX futures open interest in the era of the volatility ETN.

 

VIX Futures Short Term Open Interest

Things have heated up a bit in 2012…

 

Credit Suisse’s halt to TVIX share creation on February 22nd (horizontal black bar on chart), doesn’t seem to have slowed things up.   The CBOE’s March 6th announcement that they have reached a record open interest of  280,000 VIX futures contracts (including all their volatility futures) is not surprising.

 

Clearly the volatility ETN/ETFs (see Volatility Tickers for the full list) are on a huge growth spurt.   Their volumes now dominate the VIX futures market—but so what?  It wouldn’t be the first time broad retail acceptance of a product overtook the institutional/commercial market (e.g, computers).    Yes they have a characteristic monthly pattern, but the term structure doesn’t show any sign of that demand distorting the prices—I would expect a bump in the M2 prices if that was the case.

 

Credit Suisse at least is feeling the growing pains, but so far Barclays and ProShares (the other rapidly growing fund provider) aren’t complaining.

 

 According to Jared Woodard of Condor Options, the variance swaps aren’t out of whack, and I don’t see any evidence that SPX options are  behaving strangely.     I understand that shifting $50 million or more a day to rebalance an ETN with a billion dollars in assets is not a trifling thing, but compared to the $10 trillion market cap of the S&P 500 this feels like a tempest in a teapot.

 

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