Gaining exposure to volatility has never been so easy for investors following the introduction of volatility ETNs and ETFs, some of which have surged in popularity. The most successful providers in this space – iPath, VelocityShares, ProShares, UBS and Source – have together accumulated billions in assets.
The inefficient share creation process and the speculative motive of uninformed, return-chasing investors was to blame for the VelocityShares TVIX fiasco, suggests EDHEC-Risk Institute.
However, not all is so rosy.
Credit Suisse, the issuer of VelocityShares ETNs, has found itself fighting a class action lawsuit following the chaotic slump in the price of its NYSE-listed VelocityShares Daily 2x VIX Short Term ETN (TVIX) earlier this year. [See Lawsuit filed against Credit Suisse for VelocityShares TVIX ETNs debacle].
In the wake of this incident, EDHEC-Risk Institute, a leading European financial research centre, has published a new study entitled ‘The Risks of Volatility ETNs: a Recent Incident and Underlying Issues’. The study sheds light on the nature of volatility ETNs and the issues involved in the TVIX crisis.
EDHEC-Risk’s analysis of the TVIX incident indicates that the distortion was created by factors specific to ETNs, with no relation to the particular exposure to a volatility index. The main cause, the study suggests, was the inefficient share creation process and the speculative motive of uninformed, return-chasing investors.
The research shows that under normal market conditions, short-selling can suppress the accumulation of positive premiums. However, if share creation is suspended during a significant surge in demand (as was the case with TVIX) the security may become unavailable for borrowing, which limits short-selling activities.
The study notes that the volatility exposure through volatility exchange-traded products (i.e. ETNs and ETFs) is typically to a constant-maturity VIX futures index that can differ substantially from the spot VIX index. Short maturities are characterised by higher sensitivity to VIX but also higher roll-over costs.
Overall, EDHEC-Risk cautions that investors in volatility ETNs need to be aware that the underlying that the product is tracking does not correspond to the actual volatility index but to a systematic strategy of investing into volatility index futures, and that an ETN risks having its returns decoupled from the underlying.
Product providers, on the other hand, need to ensure that sufficient education is provided to investors on the limits of such products in order for the significant growth in these products to be sustainable.
The EDHEC-Risk study comes after a more general caution about ETNs was made by the Financial Industry Regulatory Authority (FINRA), the independent regulator of securities firms operating in the US, in July. The regulator issued an ‘Investor Alert’ warning investors of the unique features and risks of ETNs. [See US regulator FINRA warns investors of risks of ETNs].