RISK

A sud­den surge in the VIX in early Fe­bru­ary led to the ter­mi­na­tion of cer­tain ex­change­traded prod­ucts — and a harsh les­son for many in­vestors

Investment Executive - - FRONT PAGE - BY DWARK A LAKHAN

A re­cent spike in the volatil­ity in­dex taught some in­vestors a les­son.

clients who bet on or against mar­ket volatil­ity were caught by sur­prise in early Fe­bru­ary, when a sharp spike in volatil­ity fu­tures caused dra­matic swings in the value of cer­tain ex­change-traded prod­ucts with un­der­ly­ing ex­po­sure to the Chicago Board Op­tions Ex­change’s (CBOE) volatil­ity in­dex (VIX). The re­sult was trad­ing sus­pen­sions for some prod­ucts, the ter­mi­na­tion of oth­ers and at least one po­ten­tial law­suit.

The mar­ket cor­rec­tion demon­strated the high level of risk such volatil­ity-track­ing in­vest­ment ve­hi­cles carry and the im­por­tance for fi­nan­cial ad­vi­sors to en­sure clients are ed­u­cated fully on how these prod­ucts work be­fore in­vest­ing.

“This episode should serve as a re­minder for in­vestors that they must be com­fort­able with the liq­uid­ity pro­file of an ETF’s un­der­ly­ing ex­po­sure in both calm and tur­bu­lent mar­ket en­vi­ron­ments, and not sim­ply look at the av­er­age daily vol­ume of the ETF it­self when mak­ing an in­vest­ment de­ci­sion,” says David Kletz, vice pres­i­dent and port­fo­lio man­ager with Forstrong Global As­set Man­age­ment Inc. in Toronto.

On Feb. 5, the VIX surged by al­most 118% to 37 from 17 in a mat­ter of two hours of af­ter-hours trad­ing, record­ing its largest per­cent­age gain ever. The VIX is based on the im­plied volatil­ity of a bas­ket of op­tions on the S&P 500 com­pos­ite in­dex over the next 30 days. The price of an op­tion rises and drops based on ex­pec­ta­tions of mar­ket price move­ments. A higher VIX means that traders ex­pect the mar­ket to be more volatile dur­ing the next 30 days.

Given that the VIX is widely re­garded as a “guessti­mate” of mar­ket volatil­ity, in­vestors can­not buy shares in the VIX out­right. Rather, they can in­vest in prod­ucts such as ETFs that trade in CBOE fu­tures con­tracts based on the VIX’s an­tic­i­pated value.

The j ump i n the VIX early last month led the In­vest­ment In­dus­try Reg­u­la­tory Or­ga­ni­za­tion of Canada (IIROC) to halt trad­ing of two ETFs is­sued by Toronto-based Hori­zons ETFs Man­age­ment (Canada) Inc. — Be­taPro S&P VIX Short­Term Fu­tures Daily In­verse ETF (TSX sym­bol: HVI) and Be­taPro S&P 500 VIX Short-Term Fu­tures 2x Daily Bull ETF (TSX: HVU) — tem­po­rar­ily on Feb. 6 “to en­sure a fair and or­derly mar­ket,” as IIROC stated at the time. Hori­zons also sus­pended new sub­scrip­tions for units in both ETFs tem­po­rar­ily.

HVI pro­vides ex­po­sure to the Hori­zons short VIX short-term fu­tures in­dex, which es­sen­tially is the in­verse of the S&P 500 VIX short-term fu­tures in­dex (a the­o­ret­i­cal rolling fu­tures con­tract in­dex), ex­plains Mark Noble, se­nior vice pres­i­dent, sales strat­egy, with Hori­zons.

When volatil­ity fu­tures be­gan to spike in af­ter-hours trad­ing on Feb. 5, the value of short po­si­tions dropped dra­mat­i­cally, lead­ing to a loss of ap­prox­i­mately 96% in HVI.

“No North Amer­i­can-listed in­verse ETF that tracks volatil­ity was spared this [pre­cip­i­tous drop],” says Noble, not­ing that some U.S.-listed ETFs suf­fered al­most iden­ti­cal losses dur­ing the same pe­riod.

HVU, in con­trast, takes a two times long po­si­tion in VIX fu­tures, so its gains and losses are mag­ni­fied twofold. As a re­sult, that ETF’s price spiked in cor­re­la­tion with the surge in the VIX.

Al­though HVU was not neg­a­tively af­fected by af­ter-hours trad­ing i n the VIX, trad­ing i n that ETF was halted by IIROC be­cause, says Noble, the “reg­u­la­tors needed to en­sure that sta­bil­ity re­turned to the mar­ket prior to the re­sump­tion of trad­ing.”

Else­where in the world, volatil­ity-track­ing ETFs and ex­change­traded notes (ETNs) ex­pe­ri­enced var­i­ous lev­els of losses and gains as a re­sult of the spike in volatil­ity. In the case of Switzer­land-based Credit Suisse AG’s Ve­loc­ity Shares Daily In­verse VIX Short-Term Ex­change Traded Note (NAS­DAQ sym­bol: XIV ), the losses were so se­vere that the prod­uct was delisted.

Based on XIV’s prospec­tus, if the value of the ETN is equal to or less than 20% of the prior day’s clos­ing value, an “ac­cel­er­a­tion event” is trig­gered and XIV would be liq­ui­dated. The value of the ETN had dropped by 93% in af­ter-hours trad­ing on Feb. 5. As a re­sult, NAS­DAQ sus­pended trad­ing on XIV and sub­se­quently delisted it.

No­mura Eu­rope Fi­nance NV also an­nounced the early redemp­tion of Next Notes S&P 500 VIX Short-Term Fu­tures In­verse Daily Ex­cess Re­turn In­dex ETN, listed on the Tokyo Stock Ex­change, as a re­sult of sim­i­lar sharp losses.

“This was not a case of ETFs ‘mis­be­hav­ing’ or the ETF struc­ture break­ing down. In re­al­ity, these prod­ucts did what they were sup­posed to do,” says Kletz. “The un­der­ly­ing de­riv­a­tives ex­po­sures of these ETFs are re­set on a daily ba­sis — some are lever­aged up to three times — which means that sharp volatil­ity spikes can cause out­sized losses.”

Kletz sug­gests that “volatil­ity ETFs rep­re­sent yet an­other tool for in­vestors to mod­ify the risk fac­tor ex­po­sures and tac­ti­cally po­si­tion their port­fo­lios. [These ETFs] are meant to be daily trad­ing ve­hi­cles, not ‘buy and hold’ in­vest­ments.”

In­vestor ed­u­ca­tion is vi­tal for these prod­ucts, Kletz adds. In fact, lack of ed­u­ca­tion is the sub­ject of an in­ves­ti­ga­tion into XIV by Klay­man & Toskes PA, a Florid­abased ar­bi­tra­tion law firm, on the grounds that “rec­om­mended in­vest­ments in these se­cu­ri­ties were un­suit­able for many in­vestors who did not un­der­stand the risks as­so­ci­ated with the in­vest­ment strat­egy, which were not ad­e­quately dis­closed.”

De­spite the risks volatil­ity-track­ing ETFs carry, they have be­come very pop­u­lar — es­pe­cially in the U.S. Says Kletz: “ETFs based on the VIX — both long and short — have be­come highly pop­u­lar and at­tracted bil­lions of dol­lars of in­flows. The sub­dued mar­ket en­vi­ron­ment in re­cent years has con­trib­uted to the ap­peal of short volatil­ity ETFs, in par­tic­u­lar.”

How­ever, Kletz adds: “With sig­nif­i­cant dif­fer­ences to typ­i­cal buy-and-hold in­vest­ments, volatil­ity ETFs gen­er­ally are bet­ter suited for ex­pe­ri­enced in­vestors who have a firm grasp on how they are con­structed and be­have.”

The prod­ucts are not in­tended for cau­tious in­vestors, Noble adds: “HVI and HVU are spec­u­la­tive in­vest­ments and are, by na­ture, very volatile. They’re ap­pro­pri­ate for [in­vestors] try­ing to profit or spec­u­late on swings in volatil­ity.”

Clients who are look­ing to re­duce volatil­ity in their port­fo­lios should be look­ing for ways of re­duc­ing risk, Noble says: “There are nu­mer­ous ways to do this, whether it’s buy­ing puts; more con­ser­va­tive in­vest­ments, such as lower-beta stocks or gov­ern­ment bonds, which his­tor­i­cally have lower volatil­ity; or even in­creas­ing lev­els of cash.”

Heather Hol­je­vac, se­nior wealth ad­vi­sor with TriDelta Fi­nan­cial Part­ners Inc. in Oakville, Ont., says “man­ag­ing volatil­ity and risk is all about man­ag­ing ex­pec­ta­tions.”

Specif­i­cally, she says, you can help your clients man­age risk with tra­di­tional in­vest­ment prod­ucts, with­out hav­ing to in­vest in volatil­ity-based prod­ucts.

“In­vestors must be com­fort­able with the liq­uid­ity pro­file of an ETF’s un­der­ly­ing ex­po­sure in both calm and tur­bu­lent mar­kets”

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