The TVIX (NYSEARCA:TVIX) has been responsible for some unusual trading recently. The index, which promises to double gains on the VIX volatility index, was down 30% on March 22nd as the VIX rallied, and in the last few days as the VIX rose 22% the TVIX was only up by 16% when it should have been up 44%. The volatility in the volatility tracker has caused doubt as to the index’s future. Media releases from the end of March revealed that the SEC was reviewing the product, a move that could set back the product by great measure if the regulators rule negatively.
Exchange Traded Notes, or ETNs, are a relatively young financial instrument. They were initiated by Barclays in June 2006 and so are far too young to accurately predict their potential in the market. The problems with the TVIX have brought scrutiny on the instruments to a head with investors worried about the stability of the instruments.
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The TVIX seems like a simple proposition to investors that don’t comprehend the complexities of the product. It should provide a return of double on the VIX daily though recent results has shown its not quite as simple as that. The TVIX is surrounded by an obfuscating mist because of its distant removal from the assets it is actually following.
It tracks the VIX volatility index, which in turn is a proxy for volatility in the S&P 500. Many people are buying the VIX as a hedge against a market downturn, as the index hits five year lows.
The mathematical leaps required in its calculation should be enought to turn investors who don’t have a reasonable understanding off of the product, though apparently this is not the case.
The TVIX underlying structure is what’s responsible for the shifts in its price, it’s not magic it is the internal complexity of the instrument that has made it difficult to follow and has resulted in it underperforming. The promise of a daily doubling of return on the VIX was one that could not be kept and according to the instrument’s prospectus was not actually made.
That document says that the value of an ETN is subject to external factors including supply and demand something many investors obviously overlooked. The influence of external factors became apparent in February when Credit Suisse Group (NYSE:CS) stopped offering new units of the TVIX, that caused a surge in price and resulted in a large fall once units were issued again in March. The cessation of unit issue essentially caused the instrument to become almost entirely isolated from the index it was supposed to have been following.
Investors who did not understand the risks got burned while investors who could see what was going on, including many funds, shorted the instrument revealing a substantial information and comprehension gap between different types of investors. Trading in the product became incredibly liquid in February as its price increased to far above its intrinsic value and the level of shorts more than tripled overnight after the announcement. It was that more than anything else which revealed the real difficulties with the platform and caused the SEC to prick up its ears.
The SEC started a huge investigation into ETFs, a close cousin of the ETN, last October. Though that inquiry has a different focus it may broaden its horizon to include ETNs after the recent slew of negativity surrounding the product. The SEC may find that it is inherently unstable and unfair to investors. As it stands ETNs are still trading and the popularity of the TVIX has caused more volatility based indexes to pop up. I
nvestors should watch out, caveat emptor, as those without a sophisticated understanding of the relationships between the instruments, their indexes, and external market forces operating on them, is a complex one and as the TVIX has shown not worth the risk as a simple instrument.
ETNs are too young to fully understand the effects they have on the market and vice versa. They offer new strategies to investors and their flexibility and liquidity are hard to find anywhere else. That said the instrument seems inherently unstable and nobody should forget the lesson of the TVIX.
The product is not for those looking for a double return on the VIX. Watch this space as the SEC circles and investors become increasingly wary of this unstable overly complex product.