It’s Time For An ETF Gate

March 29, 2012

With headlines still screaming about TVIX, maybe it’s time regulators start thinking seriously about gated access and ETF reform.

Normally I consider it a good thing when my phone rings off the hook with reporters asking smart ETF-related questions.

But the last two weeks have been a bit more of a grind than usual. Enough that I think perhaps it’s time for Washington to get serious.

The phone calls have come in a few flavors, all driven by the VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX).

As we’ve covered here extensively over the past month, TVIX experienced an enormous premium spike after Credit Suisse—the ETN’s issuer—halted creations, and then experienced a subsequent premium collapse just before Credit Suisse announced a limited restart of creations.

What’s so interesting to me here is what it takes to get people riled up.

To me, the rise and fall of TVIX was entirely unsurprising. After all, once creations are halted in any exchange-traded product, they effectively become closed-end funds. Since the redemptions aren’t generally halted, the pressure is purely for the fund to trade at a premium.

That premium on TVIX, however, was kind of insane, because anyone who wanted the underlying exposure could just as easily have an ETF version of the same product from ProShares (NYSEArca: UVXY). In fact, if you were holding TVIX when the premium appeared, you could have simply sold it and bought UVXY and immediately pocketed the difference.

My assumption is always that those folks buying in a spike like this are serious Wall Street players who are gaming a momentum chart and hunting for greater fools.

But then, there’s this morning’s Wall St. Journal article, which features the sad story of a man named Eric Brehm, who bought TVIX as a hedge against his portfolio on Feb. 22—the day Credit Suisse halted creations. The Journal has used Eric as a poster child for what happened in TVIX, but the problem here isn’t one of TVIX—it’s one of poor judgment.

Eric bought TVIX as a “hedge” against a market downturn. Since Feb. 22, the S&P 500 is up almost 4 percent. The VIX itself is down 14.95 percent, and even the most naive-guess on what -2X VIX means should be puts him down 30 percent.

Of course, you can’t buy VIX, so TVIX—and every other volatility product—tracks VIX futures. Because it’s a leveraged product, it has to rebalance daily—as the name of the product suggests.

The impact of that daily rebalancing, plus the substantial contango in VIX futures would suggest Eric “should” have lost 56.71 percent. That’s how much the index TVIX is tracking is down, once you include TVIX fees. That’s the NAV loss. How much did Eric lose? Well, the actual market value of TVIX is down 57.41 percent.

These NAV and price-return figures are almost identical to the equivalent ProShares product, UVXY, which is structured as a commodities pool.

Of course, in between when Eric bought it and today, he saw the price shoot up, in no relation to the underlying value of his investment. So perhaps he thought he was a genius for betting on TVIX, and is lamenting his paper losses. But the bottom line is that his bet on 2X volatility futures was a terrible idea.


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