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As Investors Look To Hedge Risk, ETN Product Raises Questions

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As the markets have risen to significant new highs over the past two years, some say on the back of artificial Federal Reserve stimulus, certain investors are looking to hedge their portfolios against a potential stock market bubble bursting as the stimulus is withdrawn.  The need for portfolio protection has driven the popularity of a once troubled investment vehicle: a volatility-based exchange traded note (ETN), a cause of concern in some corners.  In particular, the Credit Suisse AG – VelocityShares Daily 2x VIX Short Term ETN (NASDAQ:TVIX) is witnessing a renaissance despite its troubled past.

Above: two year performance of TVIX. Chart source: Yahoo

Product designed to mimic volatility index which rises when stock market fails

Volatility Vix two year ETN

Above: two year performance of the underlying VIX index. Chart source: Yahoo

The TVIX product was designed to mimic movements in the popular VOLATILITY S&P 500 (INDEXCBOE:VIX) volatility index, the futures of which traded at the CBOE Holdings, Inc (NASDAQ:CBOE), delivering two times the performance, but something went terribly wrong.  The VIX index is a measure of stock market volatility, known as the “fear index,” and has risen in value 80% of the time when the broad stock market has fallen in price, making it one of several good choices to hedge risk.

Credit Suisse ETN investigated by SEC

In 2012 the Securities and Exchange Commission investigated the Credit Suisse ETN because their TVIX product delivered very different performance from the underlying VOLATILITY S&P 500 (INDEXCBOE:VIX) index, whipsawing investors through volatile price swings.

Now, investors appear to be piling back into the product, according to a Bloomberg report.  Despite this checkered past, trading volume in the TVIX product is up nearly 500% year over year to nearly 188 million shares traded monthly and investors have allocated nearly $80 million into the security this year along, according to the report, making it one of the 20 most-traded U.S. exchange-traded funds and notes.

“Market participants almost always have too short memory,” Mark Shepherd, president of Chicago-based Derivative Strategy Consultants, was quoted as saying.  “When there’s momentum in a product like the TVIX, people start following a trend without being careful and they all feed on each other.”

TVIX performance different from underlying VIX

As the stock market has risen throughout 2012, the performance of the TVIX has been less than stellar year-over-year, as the product has dropped from near $45 in April to its current price near $8.

“It could be people who are not familiar with the product’s history and see that two times VOLATILITY S&P 500 (INDEXCBOE:VIX) performance and get excited,” Todd Salamone, senior vice president of research at Schaeffer’s Investment Research, was quoted as saying. “Regardless of the motivation for trading it, there’s a growing interest for these products driven by uncertainty about the direction of the market.”

Risks disclosed in prospectus

Credit Suisse, for its part, did not comment on the Bloomberg report, and has appeared to comply with all disclosure laws.  In the TVIX 96-page prospectus, Credit Suisse said new share issuance may depend on the market’s willingness to sell the bank a hedge for the security, such as swaps. Any limitation on new shares created may “materially and adversely” affect price and liquidity, the report said, citing the Zurich-based bank.  As with all leveraged investment products, leverage can magnify both gains and losses, something Credit Suisse discloses to investors in its prospectus.  Typically buried in the fine print of voluminous pages of disclosure, the investment product does not guarantee that it will mimic the performance of the VIX.

The lack of performance replication is one issue, but not the only concern. The report notes that the TVIX has an annual expense ratio of 1.65 percent, compared with 0.95 percent for the ProShares Ultra Silver (ETF) (NYSEARCA:UVXY), which also advertises delivering double the VIX return.  “It is very expensive to carry on this product,” Francois Chaulet, who helps oversee $350 million at Montsegur Finance SAS in Paris, was quoted as saying. “You have to be right on timing if you buy this.”

Regulators can’t make decisions for investors, only provide information and make sure players follow disclosure rules

In addition to the SEC, other regulators have sounded the warning bell.  In July of 2012 The Financial Industry Regulatory Authority (FINRA) published an alert, “Exchange-Traded Notes — Avoid Unpleasant Surprises,” that clearly said the securities can be illiquid and don’t always track their underlying index.  While such alerts seldom get onto retail investors radars, the assumption is that financial advisors and professional investors, who have a fiduciary responsibility, would monitor such activity.

ETN: Enhanced product

The report discusses adjustments that have been made that enable the product to more easily hedge the TVIX shares. The TVIX price, the report noted, has been 1.3 percent above its underlying assets on average this year, the least since 2011, data compiled by Bloomberg show.

“The rise of other VIX products means the Credit Suisse AG – VelocityShares Daily 2x VIX Short Term ETN (NASDAQ:TVIX) plays a smaller role in the market than it did in 2012, so Credit Suisse may not be worried about getting trapped,” said Bill Luby of Luby Asset Management LLC. “People are getting comfortable now with volatility as an asset class and the revival of the TVIX is probably a sign of that.”

ETN providers may be aided by record trading in the underlying VIX futures, the report said. Average daily trading in VIX contracts has risen about 30 percent this year to 200,000 contracts, data compiled by Bloomberg show.  The roughly 4 million monthly VIX contracts traded dwarfed by the 188 million monthly shares traded in the Credit Suisse ETN, which is marketed as a replication of the VIX.

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