Written on 25 September 2012.
In the wake of the incidents of spring 2012 involving the TVIX ETN issued by Credit Suisse, EDHEC-Risk Institute has published a new study entitled “The Risks of Volatility ETNs: a Recent Incident and Underlying Issues,” which sheds light on the nature of volatility ETNs and the issues involved in the TVIX crisis.
EDHEC-Risk’s analysis of the incident indicates that the distortion was created by factors specific to ETNs, with no relation to the particular exposure to a volatility index. The main factors suggested by the academic literature are the inefficient share creation process and the speculative motive of uninformed, return-chasing investors. Under normal market conditions, short-selling can suppress the accumulation of positive premiums. However, if share creation is suspended during a significant surge in demand the security may become unavailable for borrowing, which limits short-selling activities.
The EDHEC-Risk study notes that the volatility exposure through volatility exchange-traded products is typically to a constant-maturity VIX futures index that can differ substantially from the spot VIX index. Short maturities are characterised by higher sensitivity to VIX but also higher roll-over costs.
Overall, investors in volatility ETNs need to be aware that
(i) the underlying that the product is tracking does not correspond to the actual volatility index but to a systematic strategy of investing into volatility index futures, and
(ii) an ETN risks having its returns decoupled from the underlying.
Product providers, on the other hand, need to ensure that sufficient education is provided to investors on the limits of such products in order for the significant growth in these products to be sustainable.
A copy of the EDHEC-Risk study can be downloaded here: