Mind the Gap

Hidden problems and greed explain why these ETFs mysteriously shut down

The popularity of alternative risk premium products has steadily grown in response to nine years of negative to low interest rates

PUBLISHED : Sunday, 11 February, 2018, 6:02pm
UPDATED : Sunday, 11 February, 2018, 11:37pm

Easy come, easy go. That’s the only way to describe the end of easy returns selling low volatility for years after recent sharp market declines and high volatility. Selling volatility in a market that had been steadily rising was one of those sure things made easier by information and execution technology and exotic products such as leveraged and unleveraged exchange traded funds (ETFs).

The popularity of alternative risk premium products has steadily grown in response to nine years of negative to low interest rates. Many of these securities are bundled with attractive names like ultrashort, double long or inverse. They benefit from the transparency associated with other ETFs, sound regulations, public listings and specialised index tracking supported by reputable institutions.

“Movement in the VIX index was not random and the size of the positions being moved caused a cascade. This move was caused by portfolio re-hedging and rebalancing and algorithms reacting to market signals,” said Tobias Bland, CEO of Enhanced Investment Products. “For a long time, selling volatility for more yield in a low yield environment was a free lunch, but no more.”

This is being unwound as the leverage behind those trades are being deleveraged. Since 2009, this leveraged risk became longer duration, more risky, more illiquid as investors sought higher returns.

The bet went so awry that the ETFs’ termination clause was triggered to close the fund when the notes lost more than 80 per cent of their value during the market drop. The termination clause allows the manager/underwriter/market maker of the fund to wind it down. After all, a fund with a negative NAV puts the manager in the odd legal position of owing investors money. But, like most prospectus terms, no one pays attention until something bad happens.

The result is an almost total loss for investors. Nomura’s redeemed its notes at a 96 per cent discount. Nomura also invoked its termination clause for its “Next Notes S&P500 VIX Short-Term Futures Inverse Daily Excess Return Index ETN”. And for similar reasons, Credit Suisse closed their “VelocityShares Daily Inverse Vix Short-term Exchange Traded Note.”

Losses in this ETF class have so far been confined to about US$4 billion compared that to the notional US$120 billion that vanished in the cryptocurrency market. But, watch for second order, rippling affects in the OTC market as notes issued by banks referencing volatility may have to be written off. Let’s see if post-crisis regulations and compliance actually work.

Exchange traded funds are easy to access by retail investors because they are listed, which increases the temptation to trade them. But, investors face two built-in problems with index ETFs.

The key word in the prospectus is “daily”. A leveraged or unleveraged ETF referenced to an index is repositioned at the close of the market. The ETF provider must take positions- adjusted daily- for it to pay out its commitment. Leveraged ETFs are especially difficult to manage if you hold them beyond their daily rebalancing period. But, they are useful to professional traders trying to manage or hedge intra-day volatility as they position a trade.

Beyond their daily usefulness, their risks are greater on the downside than they are on the upside. A simple mathematical example is if you bought in at a value of 100 and the ETF declined by half to 50. For the investor to return to his base of 100, he would have to double his return from 50.

Once your position gets away from you, it is easy to exceed the point of no return then the ETF market maker can extinguish the fund. As they say at the casino tables, “Thank you for playing. Please come again.”

Peter Guy is a financial writer and former international banker