Macro Risk Advisors’ (MRA) Dean Curnutt has picked on a very interesting development in the land of volatility ETNs. In the last few days there’s been an absolutely astounding amount of vega trading through these products.
As he notes:
One client summarized the situation as “the volatility ETNs are the dog and SPX implied vol is the tail.”
The above applies to two products specifically, the VXX — the long-standing Barclays iPath ETN whose strategy is focused on rolling across short-term Vix futures — and TVIX, a 2x levered VXX product marketed by US-based* VelocityShares, but backed by Credit Suisse and launched in November 2010.
It’s the sudden growth in the shares outstanding of the latter — to 35.725m this February week versus less than 6m in December 2011 — which is perhaps the most eye opening:
Though shares outstanding in the VXX have also been rising steadily:
Here, meanwhile, courtesy of MRA is a table showing the recent burst of volume in Vix future and Vix ETN vega that has accompanied that spike:
According to Curnutt, both the increase in shares outstanding and volume could have significant repercussions for the volatility market and may increase the risk of a “disconnect between implied and realized volatility”.
As he notes, close-to-close realised volatility for the SPX — which Vix is derived from — has registered an anaemic 8 per cent over the past 30 days and 9.4 per cent over the past 10 days. But implied volatility (as registered by Vix) has picked up considerably more:
While part of this could be down to Greek fears, the magnitude of the move in implied volatility relative to realised suggests — at least in his opinion — that other forces are in play.
The key concern for Curnutt is the potential impact on rebalancing. Just like all levered ETFs, the fund manager is obliged to rebalance the portfolio at the end of each day to reset the 2x exposure. The larger the move in the underlying index, the larger the rebalance required.
Theoretically, Curnutt notes:
… we look at the theoretical TVIX rebalance for -2 to +2 point move in the VIX futures basket as of today. (We assume the TVIX shares outstanding remains constant). And just a point of reference, the VIX Mar future traded 48k contracts yesterday, meaning the +2pt rebalance represents 9.5% of the total volume of a busy trading day! This is a significant effect that should be closely watched.
Though, we should point out, there is the possibility that the fund manager isn’t hedging every share in the underlying Vix futures market itself.
As the prospectus notes:
We intend to use the net proceeds from this offering for our general corporate purposes, which may include the refinancing of our existing indebtedness outside Switzerland. We may also use some or all of the net proceeds from this offering to hedge our obligations under the ETNs of the applicable series.
One or more of our affiliates before and following the issuance of the ETNs of any series may acquire or dispose of the futures contracts underlying the applicable Index, or listed or over-the-counter options contracts in, or other derivatives or synthetic instruments related to, the applicable underlying Index or the S&P 500 ® Index or the VIX Index to hedge our obligations under the ETNs of such series. In the course of pursuing such a hedging strategy, the price at which such positions may be acquired or disposed of may be a factor in determining the levels of the applicable underlying Index.
In other words, the products can be hedged in any number of illustrious ways, from synthetic instruments to over-the-counter options, Vix-index based securities to S&P 500 index-based securities. There is no obligation for the hedging activity to take place in Vix futures themselves.
Vix futures are only used to calculate the indices that the ETNs track, and the returns that they are obliged to deliver. An ETN, as always, presents an unsecured exposure to the issuer — who in the case of TVIX is Credit Suisse. There is no underlying collateral that backs the shares.
*Not to be confused with India’s VLS Securities, which is a different firm.