Volatility ETFs Often Own All VIX Futures
March 01, 2012
When TVIX halted creations last week, it caused a lot of people to look at this tiny little corner of the ETF market.
With just 14 products and a bit more than $2.5 billion in assets, it’s easy to dismiss it. In fact, on these very pages, we’ve been quoted talking about how the VIX products are largely irrelevant for most investors.
We stand by that assessment. VIX—an index of the implied volatility in the S&P 500 options market—is a curious beast. It isn’t the actual volatility of the S&P 500; that’s a number that’s easy to calculate.
At the time of this writing, the trailing 30-day volatility of the S&P 500 was 8.58 percent. What that actually means is that 66 percent of S&P 500 returns for a one-year period should fall between +/- 8.58 percent of a mean return.
It’s something of a goofy figure to start with—annualizing a short-term reading on volatility can lead to wildly unbelievable numbers. If you did it on two days’ worth of returns, you could end up with volatility numbers that have never actually been realized by the market, even in its best and worst years.
Still, it’s a measurement that makes sense in relative terms: It is rational to say that an index with a volatility reading of 10 percent is twice as volatile as a different index, measured the same way, with a volatility reading of 5 percent.
Then there’s VIX. VIX, rather than being any measurement of real volatility, is a measurement of the expected volatility in the S&P 500, as implied by a strip of S&P 500 options.
That VIX isn’t a particularly useful measure of volatility is something we’ve ranted about before. But that’s actually a bit beside the point.
Wall Street, always on the lookout for a new way to burn up money, has fallen in love with the VIX, and in particular, with VIX futures and ETFs. About $2.6 billion in short-term volatility-based ETFs is nothing to sneeze at.
The headlines have focused tightly on these products in recent weeks, as the second-largest product in the space, the VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca: TVIX), halted creations. This led to innumerable articles in the mainstream press asking a simple question: Why?
The answer, it turns out, is that any rational investor would look at the VIX futures market and run away screaming.
Let’s get some numbers on the table. As of a few days ago, here’s what the short-term VIX ETF market looked like:
A few things to point out here: Most of these products don’t actually hold VIX futures. Most of them are exchange-traded notes.
In those cases, rather than the product holding anything, there is a simple counterparty arrangement, either with the bank issuing the ETN or an independent swap counterparty. The actual notional position those counterparties have to take is the sum of their exposure.
So, for instance, imagine that VelocityShares had just two ETNs in the market—VIIX, the short-term long VIX futures product, and XIV, its inverse. If both products had the exact same assets under management, the net exposure for Credit Suisse, the bank backing the notes, is zero. After all, for every dollar VIIX moves up within a day, XIV should go down.
Of course, because of the daily resetting that happens with the inverse and leveraged products, the likelihood of these exposures staying matched up is very small. The sole exceptions are ProShares ETFs, which actually hold the futures contracts, even the levered funds, so there’s no netting-out effect.
Still, to understand the “actual” exposures of the ETF issuers, you need to do two things. You need to net out their exposure, and you need to remember that most of these products don’t just track front-month futures. They track an index that blends first- and second-month VIX futures and shifts that allocation every single day. So here’s what that exposure looked like on Feb. 24:
A quick back-of-the-envelope calculation yields a pretty interesting set of numbers. As an industry, ETF issuers are net long over $1.5 billion of front-month exposure, and over $600 million of second-month exposure.
Since we’re constantly defending the ETF industry as being “too small to be a systemic threat,” we initially assumed this was no big deal. But then we ran the numbers on the actual open interest in VIX futures:
To be honest, our initial reaction here was “holy cow!”
For all intents and purposes, this small handful of ETFs effectively is the market for short-term VIX futures. And that’s actually more of a problem than you might even think.
Because most of the products need to rebalance daily—pro-cyclically—this means there’ll always be buyers on the days when the VIX is up, and sellers when the VIX is down. This has the effect of making VIX futures more volatile.
It gets worse. The main index tracked by these funds is the S&P 500 VIX Short-Term Futures Index. This index is 100 percent in the front month only on roll date—most recently, Feb. 15. On every other day in a given month, the fund will be a net seller of the front month and a net buyer of the second month, as it slowly and continuously legs into the next month.
Why is this a problem? Because it’s entirely game-able. Generally, front-running ETF trading is a loser’s game—creations happen in-kind, and are unknown until after the fact.
But in ETNs and swap-based ETFs, the creations and redemptions happen in cash, and there’s no guarantee the counterparties are immediately putting on the underlying hedge.
But here, the issue isn’t flows. For VIX futures, the bulk of trading is being done, not in connection with asset flows, but because of the constant rebalancing of the underlying index. Here’s how this affected, for instance, the weighting of the March contract through the last rebalance across the various ETFs.
Since ETFs are the primary buyer in the market and their trading is predictable, whoever is on the other side of those transactions is in the catbird’s seat.
They can bid up the price of the second-month futures constantly, and depress the price of the front month the closer it gets to expiration. This creates a kind of inexorable contango maelstrom, which is brutal for long-holders of the ETFs.
But wait, we’re not done. It gets even worse. The snapshot we’re presenting here is from just one day.
If you look more broadly over the course of the last month, at times the ETFs represent the entire market for a given contract. Here’s the history of the ETF ownership of the March VIX contract, for instance:
The seemingly nonsensical situation where the funds own more than 100 percent of the actual futures is easily explained—the ETN counterparties are under no obligation to actually use the futures markets to offset their risk.
It’s entirely possible that the risk desk at Credit Suisse could offset their VIX risk by using the options markets, or they might have a counterbalancing short-VIX obligation from an unrelated, non-ETN client.
The contango effect, of course, ripples out over out-month contracts as well.
Because people know, more or less, that this massive buying pressure will exist in the April contract next month, they can start positioning for it now. That’s why you end up seeing massive contango out through multiple contracts, and a VIX futures curve that looks like this:
Last year (the pink line) contango wasn’t pretty. But it’s gotten uglier as more assets have flown into the ETFs.
So how does this all tie back to Credit Suisse? Well, looking back at the past month, ask yourself this question: Would you want to be the only buyer in one of the most volatile markets in the world? So, is it any wonder Credit Suisse called “uncle” and decided to stop taking new money?
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