Under the hood of TVIX and XIV—Cause for Concern


Updated: Oct 3rd, 2012 | Vance Harwood | @6_Figure_Invest

Since Credit Suisse’s recent pause on TVIX share creations I have been trying to figure out some of the hedging / rebalancing dynamics underlying the current crop of volatility ETNs and ETFs.  Traditional equity ETFs like SPY, the S&P 500 index tracking  fund don’t  require much behind-the-scenes action.   Shares are created or redeemed in conjuction with baskets of securities changing hands.  The only dynamic part is when the S&P index itself adds or deletes stocks or perhaps shuffling of shares for tax purposes.

Volatility ETNs/ETFs on the other hand use VIX futures, which themselves have only been in existence 8 years, as the underlying securities.   Rather than statically holding onto these futures all volatility funds must continually roll their futures holdings from nearer month maturities to further out months so that their effective time maturity stays constant.  In addition, except for Barclays’ offerings all inverse & leveraged volatility funds are designed to track the daily percentage move of their underlying index.  This attribute requires the funds to rebalance their holdings as often as daily to maintain their percentage tracking.     ETNs have some leeway on how they do this management of the underlying futures.  They for example can adjust the amount of hedging they have to do based on their overall portfolio (e.g., assets in XIV would partially hedge TVIX).

ETFs (e.g., ProShares UVXY 2X short term) require actual futures to change hands when shares are created or redeemed, but once held by the ETF provider they still have to do the dynamic rolling / rebalancing on the portfolio.  What you get back will be different than what you put in…

I’m concerned that the volatility ETN/ETFs are moving the market  itself with their trading: futures prices, term structure, and perhaps even the IV skew of SPX options.    It can’t help that the futures market rebalancing required to hedge vega, the volatilty of volatility, is in the same direction for both long funds like TVIX as it is for XIV and other inverse funds—the vega risk does not offset.    While scary, my analysis on the topic suggests that big VIX futures purchases probably have an overall neutral effect on the market.  The hedging activities of the market makers tend to offset the effects of VIX futures creation.

Volatility is a new asset class, and clearly it has gotten big enough to start showing growing pains.   I’m confident that the quest for profits will lead to solutions for these problems, but it will take some time to sort this all out.  I applaud Credit Suisse for having the internal controls and the willingness to take action when they saw the asset size exceed their limit.

 

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Wednesday, October 3rd, 2012 | Vance Harwood
  • Steve

    Vance,

    Wondering about alternatives to XVIX.  Any idea what a 1-1 short VXX, long VXZ would look like?  Volatility and options decided that the mix chosen for XVIX was optimized.  I would think 1-1 wouldn’t be as smooth, but probably more profitable.  Also, daily rebalancing wouldn’t be practical, but maybe monthly (or bi- or tri- monthly).

    Steve

  • Vance

    Hi Steve,
    If you are looking for a longer term volatility position I think Barclays XVZ is the currently the best game in town. It dynamically changes its position based on the volatility environment. XVIX and other static allocations (like short VXX / long VXZ) tend to have too much risk, or they get eaten up by contango.

    — Vance

  • Steve

    Hi Vance,

    I view XVZ somewhat differently than XVIX or something like a manually done 1-1 ratio XVIX.  Taking a 1-1 XVIX, I would expect it to do poorly with a big VIX rise and generally be volatile, but better than a pure VXX short risk and volatility of the position wise.  Basically, it would amount to trying to profit from a VXX short and using VXZ as a partial hedge.

    With XVZ (or VQT), in most instances (excepting a sudden event, such as described in your post below), I would expect them to act as a hedge themselves when volatility rises.  That is, when there is a big volatility spike and most of my long stock holdings are down, I would hope that XVZ would act as a stabilizing element of the portfolio.  Given that purpose, I don’t like that they are ETNs.  Still, as you suggest, I don’t think XVZ is a bad product.

    Steve

  • Vance

    Hi Steve, Your point is well taken. Harvesting contango is a dramatically different strategy than trying to benefit from volatility jumps. I was very disappointed with XVIX, so I have been a little skeptical of long / short strategies. The right mix of short / long is critical, and will probably shift over time. The increased contango in VXZ for 2010/2011 really hurt XVIX.

    I currently don’t plan to do a simulation of short VXX / long VXZ in the near future, however if you know the specific ratios / rebalancing strategies you want modeled I would be willing to do that for a pretty reasonable price. Drop me an email if you are interest in pursuing that.

    Best Regards, Vance

    — Vance

  • Steve

    Thanks for the offer.  I think I’ll pass for now,  but will let you know if I change my mind.