Volatility blow-up leads to inverse VIX ETN casualty

Feb 6th, 2018 | By | Category: ETF and Index News

This week’s spike in US equity market volatility led to the temporary suspension of trading in three US-listed inverse VIX exchange-traded products and the decision to close one of the three products following heavy losses.

Volatility blow-up leads to inverse VIX ETF casualty

The VIX Index spiked from 17 to an intraday high of 50 points following a sell-off in US equity markets. (file image)

Trading in Credit Suisse’s VelocityShares Inverse Vix Short-Term ETN (XIV US) and VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV US), as well as the ProShares Short VIX Short-Term Futures ETF (SVXY US) was ceased as the ETPs began experiencing massive declines in value.

All three ETPs were slapped with short-sell restrictions.

While trading has since resumed across all three products, Credit Suisse has announced that the VelocityShares Inverse Vix Short-Term ETN will be liquidated as of 20 February 2017.

Although there are variations between the strategies underlying the three ETPs, each essentially provides inverse exposure to the volatility of US equities represented by the VIX index.

The VIX index, also known as the ‘fear index’, represents the implied volatility of US equities, derived from option pricing on the S&P 500. It is a measure of the market’s expectation of stock market volatility over the next 30-day period.

As the US equity market quietly chugged higher over the past year, volatility and the VIX reached record lows. At the end of last week (2 February 2018), the VIX was trading between a range of 14 -17.

However, US stocks suffered their worst fall in over six years on Monday 5 February brought on by concerns over higher interest rates. The Dow Jones Industrial Average lost 4.6% and the S&P 500 tumbled 4.1%.

The sell-off caused a spike in the VIX which traded towards 50 as markets opened in the US on Tuesday morning.

CBOE Volatility Index(INDEXCBOE:VIX)

CBOE Volatility Index (INDEXCBOE:VIX) (Source: Google)

The rapid jump in the VIX, especially from such a low base, led to substantial losses in short VIX ETNs. This was most pronounced in the products providing exposure to the VIX based on shorter term futures contracts with the VelocityShares Daily Inverse VIX Short-Term ETN shedding 85% of its value in after-hours trading on Monday and closing down 93% on Tuesday.

The ProShares product similarly lost 96% of its value over the same period.

While these are specialised products aimed at sophisticated investors, the sharp unwinding of short volatility positions has highlighted the inherent risks in such strategies.

Stephen Tu, vice president at Moody’s Investor Service, said, “The sudden collapse of inverse ETFs demonstrates how much short volatility has built in the system. We see three key risks with these products – levered strategies will continually decay toward zero by construction, short volatility products present substantial tail risk because volatility is under appreciated during a prolonged period of low volatility, and complex synthetic ETPs based on derivatives, carry basis, counterparty and credit risk.”

Although the sudden loss of value in these ETFs caused Credit Suisse to announce the closure of its short-term inverse VIX ETN, ProShares released a statement saying its product would remain open as usual, noting it acted “consistent with its objective and reflected the changes in the level of its underlying index”.

European domiciled VIX ETPs, including products from Lyxor and Boost, have experienced a similar wild ride, but appear to have traded broadly in line with their stated objectives.

The Lyxor S&P 500 VIX Futures Enhanced Roll (Lux) UCITS ETF (LVO GR) tracks the S&P 500 VIX Futures Enhanced Roll Index. This second-generation volatility index dynamically switches between a short-term VIX futures and a mid-term VIX futures, based on their relative implied volatility, in order to model a cost-efficient exposure to volatility in the broad equity market. It costs 0.60% in fees.

The Boost S&P 500 VIX Short-Term Futures 2.25x Leverage Daily ETP (VIXL LN) meanwhile provides 2.25 times the performance of a daily rolling long position in first and second month VIX futures contracts. This means that if the S&P 500 VIX Short-Term Futures Index ER, its underlying reference, rises by 1% over a day, then the ETP will rise by 2.25%, excluding fees. It has an annual fee of 0.99%.

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