Under the Hood of TVIX and XIV - Cause For Concern

Since Credit Suisse’s recent pause on TVIX share creations I have been trying to figure out some of the hedging / rebalancing dynamics underlying the current crop of volatility ETNs and ETFs.Traditional equity ETFs like SPY, the S&P 500 index tracking  fund don’t  require much behind-the-scenes action. Shares are created or redeemed in conjuction with baskets of securities changing hands.The only dynamic part is when the S&P index itself adds or deletes stocks or perhaps shuffling of shares for tax purposes.

Volatility ETNs/ETFs on the other hand use VIX futures, which themselves have only been in existence 8 years, as the underlying securities.   Rather than statically holding onto these futures all volatility funds must continually roll their futures holdings from nearer month maturities to further out months so that their effective time maturity stays constant. In addition, except for Barclays’ offerings all inverse & leveraged volatility funds are designed to track the daily percentage move of their underlying index. This attribute requires the funds to rebalance their holdings as often as daily to maintain their percentage tracking. ETNs have some leeway on how they do this management of the underlying futures. They for example can adjust the amount of hedging they have to do based on their overall portfolio (e.g., assets in XIV would partially hedge TVIX).

ETFs (e.g., ProShares UVXY 2X short term) require actual futures to change hands when shares are created or redeemed, but once held by the ETF provider they still have to do the dynamic rolling / rebalancing on the portfolio. What you get back will be different than what you put in…

Volatility Futures & Options has found a great white paper put out by Deutsche Bank that gives far more detail about this process than I have ever seen before. This paper discusses my concern that the volatility ETN/ETFs are moving the market  itself with their trading: futures prices, term structure, and perhaps even the IV skew of SPX options. It also points out some other issues that I was not aware of, for example that the futures market rebalancing required to hedge vega, the volatilty of volatility, is in the same direction for both long funds like TVIX as it is for XIV and other inverse funds—the vega risk does not offset. When the market is volatile the demand for vega hedging might make the market even more volatile—yikes!

Volatility is a new asset class, and clearly it has gotten big enough to start showing growing pains. I’m confident that the quest for profits will lead to solutions for these problems, but it will take some time to sort this all out. I applaud Credit Suisse for having the internal controls and the willingness to take action when they saw the asset size exceed their limit.