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The Risks of Volatility ETNs: A Recent Incident and

Underlying Issues

September 2012

An EDHEC-Risk Institute Publication

Institute

2Printed in France, September 2012. Copyright© EDHEC 2012.The opinions expressed in this study are those of the authors and do not necessarily reflect those of EDHEC Business School. The authors can be contacted at [email protected].

Introduction ............................................................................................................ 5

1. A Review of the Main Investable Products Linked to Volatility: Futures and ETNs .................................................................................................. 9

2. A Recent Incident: The Crisis with TVIX .....................................................13

3. Some Explanations of the TVIX Incident ....................................................17

4. Other Issues with Volatility Products ..........................................................21

5. Conclusion ........................................................................................................23

References .............................................................................................................25

About EDHEC-Risk Institute ..............................................................................29

EDHEC-Risk Institute Publications and Position Papers (2009-2012) ......33

Table of Contents

3An EDHEC-Risk Institute Publication

The Risks of Volatility ETNs: A Recent Incident and Underlying Issues - September 2012

Getting volatility exposure has become easier for investors after the relatively recent introduction of volatility ETNs (exchange-traded notes) and volatility ETFs (exchange-traded funds) and some of these products have enjoyed a surge in popularity. In this paper, we use the recent crisis with TVIX – a volatility ETN – to underline important differences between ETNs and ETFs which appear to be at the source of the observed market distortion. We also emphasize an important feature of these products – that they track constant maturity VIX futures indices rather than the VIX index itself – which has an impact on the quality of the volatility exposure because of the roll-over costs and the lack of cash-and-carry arbitrage relationship.

Abstract

4 An EDHEC-Risk Institute Publication


About the Authors

Felix Goltz is Head of Applied Research at EDHEC-Risk Institute. He carries out research in empirical finance and asset allocation, with a focus on alternative investments and indexing strategies. His work has appeared in various international academic and practitioner journals and handbooks. He obtained a PhD in finance from the University of Nice Sophia-Antipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School.

Stoyan Stoyanov is Professor of Finance at EDHEC Business School and Head of Research at EDHEC Risk Institute–Asia. He has ten years of experience in the field of risk and investment management. Prior to joining EDHEC Business School, he worked for over six years as head of quantitative research for FinAnalytica. He has designed and implemented investment and risk management models for financial institutions, co-developed a patented system for portfolio optimisation in the presence of non-normality, and led a team of engineers designing and planning the implementation of advanced models for major financial institutions. His research focuses on probability theory, extreme risk modelling, and optimal portfolio theory. He has published over thirty articles in leading academic and practitioner-oriented scientific journals such as Annals of Operations Research, Journal of Banking and Finance, and the Journal of Portfolio Management, contributed to many professional handbooks and co-authored three books on probability and stochastics, financial risk assessment and portfolio optimisation. He holds a master in science in applied probability and statistics from Sofia University and a PhD in finance from the University of Karlsruhe.


Introduction



Volatility ETNs (exchange-traded notes) are a fairly recent financial innovation with the objective of tracking a specified constant maturity volatility futures index. Despite their recent appearance, it has been reported that the market cap of such products now reaches levels of up to USD 3 billion (see Alexander and Korovilas 2012). The objective of the present note is to review how these products function and what the potential risks are.

An important issue when using ETNs to invest in volatility is that such products do not actually provide exposure to a volatility index such as the VIX. In fact, non-parametric option-implied volatility simply corresponds to information extracted from option prices. This is a key difference between volatility indices, which we also refer to as VIX-type indices, and other financial indices such as stock and bond indices, which actually correspond to portfolios of assets. VIX-type volatility indices thus are not directly investable. Volatility ETNs thus use an underlying which corresponds to a systematic investment strategy into futures written on non-parametric options-implied volatility indices. Such a futures strategy does not necessarily track the evolution of the actual volatility index. Among other issues, investors are willing to pay a premium for long volatility exposure thus making it costly to maintain long positions in such futures.

While investors naturally pay attention to the type of exposure such a product tries to achieve, an important issue is also how this exposure is structured in the product. In contrast to ETFs (exchange-traded funds), which also exist on volatility as the

underlying exposure, ETNs are essentially debt securities with typically no collateral. They are supplied to the market by the issuer and are traded on the secondary market. Another important distinction between ETNs and ETFs is given by the possibilities of arbitraging away price discrepancies between the product and its underlying exposure. The share creation process of ETFs is transparent and can be performed by market makers and arbitrageurs (a.k.a. authorized investors) by depositing the necessary securities at the custodian bank, thus making it easy for market participants to exploit any potential arbitrage opportunities. In contrast, shares of ETNs can be created solely by the issuer of the ETN.

An important issue with ETNs reported in the academic literature (see Diavatopoulos et al. (2011)) is that their price may deviate significantly from the indicative value based on the underlying index in a positive direction, i.e. they may be traded with a premium. The reason for these discrepancies, as reported by Diavatopoulos et al. (2011), can be attributed to uninformed, return-chasing investors and also to inefficiencies in the share creation process by the issuer. Such premiums can accumulate on the ETF market as well but only under specific conditions because—due to the creation and redemption mechanism of ETFs— authorized investors can easily profit from such opportunities and arbitrage them away.

Although this is a general issue with ETNs, because of the significant attention in the press on a particular incident,1 we focus on volatility ETNs and in particular on a

Introduction

1 - See, for example, the Bloomberg article “Credit Suisse VIX Note Tumbles to Record-Low Price” published on Mar 23, 2012, and available online (http://www.bloomberg.com/news/2012-03-22/credit-suisse-vix-note-tumbles-to-record-low-price.html) and also the Reuters article “TVIX Selloff Ahead of News Raises Questions” published on the same date, also available online (http://www.reuters.com/article/2012/03/23/options-tvix-idUSL1E8EN2R220120323).



specific product called TVIX and the losses that occurred to investors in this product in February and March 2012. Apart from the market distortion, a couple of legal investigations and reviews are underway. The most recent investigation was initiated in July 2012 by Wohl & Fruchter LLP and is based on the claim that Credit Suisse failed to inform investors of certain risks.2 Around the same time, FINRA, the largest independent regulator in the US, issued an alert about the risks of investing in ETNs.3

The TVIX incident opens important, more general questions about the potential hidden risks in seeking exposure to market volatility through volatility ETNs. We begin the discussion with a general overview of volatility futures and volatility ETNs followed by a short summary of the incident and a general discussion of issues related to volatility products..

Introduction

2 - See the announcement on the Wohl & Fruchter website (http://www.wohlfruchter.com/cases/velocity). 3 - The alert is available online on the FINRA website (http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P131262).



Introduction


1. A Review of the Main Investable Products Linked to

Volatility: Futures and ETNs



Investors are willing to get an exposure to market volatility for a variety of reasons, such as diversifying equity risk, hedging an existing short volatility exposure, or simply taking directional bets. However, volatility indices such as VIX are not directly investable as they simply represent a non-parametric measure of volatility extracted from option prices. This section first describes how investors can get access to investable instruments related to such volatility indices, i.e. through volatility futures contracts.4 We then explain how such exposure to volatility futures contracts is often packaged into the form of an exchange-traded note (ETN) which allows investors to avoid the operational burdens of dealing with futures positions, such as roll-over of positions.

1.1. Volatility Index FuturesFor the US market, and also globally, the most popular volatility index is VIX, which represents a forward-looking market view of the 30-day volatility of the S&P500 index derived from prices of options on this index. Although it is not itself investable, futures on VIX have been available since 2004 for

maturities ranging from 1 to 9 months. The key difference between VIX futures and VIX is that at any current point in time the futures price represents the risk-neutral expectation of VIX at the contract’s maturity and is, therefore, different from the value of VIX observed at the current point in time (see Lin (2007)). Thus, The VIX futures prices observed on a given day define a term structure which reflects investors’ expectations about future volatilities.

The term structure has two empirically observed properties—(i) most of the time the market is in contango, which means that the futures curve is upward sloping and (ii) the VIX futures prices for longer maturities are less volatile and less sensitive to the changes of VIX which is a consequence of the mean-reverting behavior of volatility.5

From a practical perspective, short-term maturity futures are more popular in getting exposure to VIX and are more liquid than the longer term contracts.

Because they are expirable instruments, a common approach to investing in VIX futures is to build a roll-over portfolio with a constant maturity. Index providers

1. A Review of the Main Investable Products Linked to Volatility: Futures and ETNs

4 - See, for example, Mougeot (2007). 5 - See, for example, Hiatt and Shalen (2007).

Figure 1. The top plot compares VIX to S&P 500 VIX Short-Term Futures Index continuously rolling out the 1-month VIX futures and rolling in the 2-month VIX futures maintaining a constant 1-month time to maturity. The scatter plot of the daily percentage changes of the two time-series from the plot. immediately below is shown



have started publishing constant maturity volatility futures indices such as S&P500 VIX Futures Index series. From an investor standpoint however, the roll-over is costly because of the contango effect. In fact, it has been established in the academic literature that volatility risk premium is negative (see, for example, Bakshi and Kapadia (2003)). A possible economic explanation of this phenomenon is that a long exposure to market volatility provides a downside protection in times of market declines and risk-averse investors are willing to pay a premium for it. Other references on pricing volatility risk include Coval and Shumway (2001), regarding option prices, and Ang et al. (2006), regarding expected stock returns.

As a consequence of the contango, the roll-over results in negative returns unless the market is in backwardation which normally happens in market downturns. This property of the roll-over leads to a divergence between the short-term constant maturity VIX futures portfolio and the spot VIX which is illustrated on the left plot of Figure 1.6 The S&P 500 VIX Short-Term Futures Index (SPVXSP) index represents the evolution of the value of

the one-month constant maturity volatility futures portfolio. The bottom plot of Figure 1 is a scatter plot of the percentage changes of VIX and that of SPVXSP. The correlation between the percentage changes is very high, 98.6%, which combined with the behaviour on the top plot implies that SPVXSP can be an efficient proxy for an exposure to VIX only over the short run because of the roll-over cost; see Alexander and Korovilas (2012a) for additional information on roll-over cost and the link with the slope of the term structure.

Finally, the connection between VIX future prices and VIX is not based on the cash-and-carry arbitrage between stock index futures and the underlying stock index, for example. The reason is that VIX is not investable. An explanation provided in the literature about why VIX future prices track VIX in the absence of cash-and-carry arbitrage is that this effect is due to the persistence of volatility, see Hiatt and Shalen (2007). Basically, expectations about the near-future volatility; very often move in tandem with expectations about the more-distant future volatility and are affected by the realized volatility in the immediate past.


6 - For other comparisons between VIX and VIX futures with different maturities, see Shu and Zhang (2012) and also Guobuzaite and Martellini (2012).



1.2. Volatility exposure through ETNsETNs are exchange-traded products which represent debt obligations of the issuer not guaranteed by any collateral. In this aspect, they bear some resemblance to bonds, but unlike bonds they pay no interest to investors. Rather, on the maturity date the issuer pays an amount which is determined by the performance of an index specified in the prospectus of the ETN. New shares of ETNs can be created or redeemed by the issuer which is supposed to lead to the ETN effectively tracking the underlying index prior to maturity. Thus, ETNs are regarded as easily accessible investment vehicles designed to track the performance of other index products. A large variety of ETNs exists on the market tracking equity indices, commodities, currencies, and volatility. Volatility ETNs in particular normally track constant maturity volatility futures indices and are broadly categorized as short-term and mid-term volatility ETNs, which can also be leveraged or inverse.7

Introduced in 2009, Barclays’ VXX and VXY started tracking the 1-month and the 5-month constant maturity VIX futures indices in the S&P500 VIX Futures Index series. The 1-month constant maturity S&P500 VIX Futures Index measures the return from a rolling position in the first- and second-month VIX futures contracts. The rolling is done on a daily basis ensuring a constant 1-month maturity. Although implemented in a different way, the same general principle is followed for the 5-month constant maturity index.8

Since 2009, volatility ETN products have increased in number to about 309 and have become more diverse including inverse (short the underlying index) and leveraged volatility ETNs (currently twice the return of

the underlying index). Both the leveraged and the inverse ETNs are supposed to be used only over the short run because the performance objectives are usually re-set on a daily basis (see, for example, Goltz and Tang (2012)).

Volatility ETN providers can take advantage of different approaches to hedge the products sold on the market. One approach is by constructing a hedging portfolio which is long or short in the underlying volatility futures depending on whether the ETN is of the standard or of the inverse type. Such hedging activity creates turnover on the volatility futures market. The providers, however, do not need to hedge all of the ETN contracts sold, only their net position. An unleveraged volatility ETN is perfectly hedged by an inverse volatility ETN and, depending on any demand asymmetry, only the net exposure needs to be hedged. Finally, providers may also choose more complex but partial hedging strategies involving variance swaps, volatility options, and also classical index option-based strategies, such as straddles, strangles, or delta-hedging option strategies. For more information on the quality of these hedging strategies, see Mougeot (2007).


7 - For additional details on ETNs, see the FINRA alert issued in July 2012 available online (http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P131262).8 - For more information, see the information provided by S&P available online (www.standardandpoors.com/indices/sp-500-vix-futures-index-series/en/us/?indexId=sp-500-vix-futures-index-series). 9 - Source: ETFdb, the category of volatility products. A comprehensive list is available online at http://etfdb.com/etfdb-category/volatility/.


2. A Recent Incident: The Crisis with TVIX



The demand for volatility ETNs has grown dramatically since the beginning of 2012. Alexander and Korovilas (2012b) report that the two most popular short-term volatility products, VXX and TVIX, accounted for USD875 million of daily trading volume on average during the first two months of 2012. Deng et al. (2012) report that the total market capitalization of the four largest exchange-traded products reached USD3.19 billion in April 2012. TVIX is the second biggest product in terms of volume but in contrast to VXX it is leveraged. The product is created by VelocityShares and is backed by Credit Suisse. According to the prospectus, it tracks 2x the returns of S&P 500 VIX Short-Term Futures Index (SPVXSP) the behaviour of which relative to VIX is illustrated in Figure 1. As reported by Bloomberg, by February 21 the market value of TVIX had more than quadrupled since December 30 and the shares outstanding had increased seven times. The surge in demand is concurrent with a bullish stock market in which the S&P 500 gained 8.3% and is consistent with the hypothesis that many investors were expecting that volatility may increase.

On February 21, Credit Suisse discontinued issuing new TVIX ETNs stating that “internal limits on the size of the ETNs” have been reached.10 There has been no further statement as to the precise nature of the cause, which could be regulatory or related to the capacity to construct hedges.

Because of the high demand for TVIX in the wake of these events, the price of the ETNs on the secondary market deviated above the indicative value. In the period from February 22 to March 23, the premium of TVIX over its indicative value increased steadily and

peaked on March 21 at almost 89%. Over the following two days, it rapidly decreased to 6.5%. The price plunge was concurrent with a statement issued by Credit Suisse on March 22 saying that, starting from March 28, they may resume issuing these ETNs conditional on availability of hedging instruments.11

In the media release issued on March 22, Credit Suisse issued a warning to the investors concerning the existing premium:

“It is possible that the resumption of new issuances of the ETNs, even on a limited basis, could reduce or remove any premium in the trading price of the ETNs over their indicative value. Investors are cautioned that paying a premium purchase price over the indicative value of the ETNs could lead to significant losses in the event the investor sells such ETNs at a time when the premium is no longer present in the market place or the ETNs are accelerated (including at our option), in which case investors will receive a cash payment in an amount equal to the closing indicative value on the accelerated valuation date.”12

The market distortion is illustrated on Figure 2. The top plot shows TVIX, its indicative value as reported by VelocityShares, and another leveraged volatility exchange-traded product, UVXY,13 which is an ETF tracking the same index and supplied by ProShares. The bottom plot shows the premium of the two products as a percentage of their indicative values. Clearly, the premium of TVIX contracted substantially shortly after the announcement of Credit Suisse, which is consistent with significant short selling by market participants expecting the premium


10 - Quoted from the pricing supplement No. VLS ETN-1/A14 to the Prospectus Supplement published on March 23, 2012.11 - Quoted from the pricing supplement No. VLS ETN-1/A14 to the Prospectus Supplement published on March 23, 2012. 12 - The media release is available on the US Securities and Exchange Commission (SEC) web-site (http://www.sec.gov/Archives/edgar/data/1053092/000095010312001467/dp29470_fwp-tvix.htm). 13 - In contrast to TVIX, UVXY is an ETF and not an ETN and is subject to a different regulation.



to disappear after issuing new contracts resumes. It has, however, remained higher than prior to February 21.

It remains unclear as to what triggered the decision of Credit Suisse to resume issuance because no legal obligations exist. There have been speculations that the reason is largely reputational risk—the most traded leveraged volatility ETN has turned into a broken product because it has become disconnected from the market of the corresponding VIX futures driving the value of the underlying index. Although not confirmed officially either by SEC or by Credit Suisse, there have been reports in the media14 about a probe by the regulator underway as of the end of March 2012 about the events regarding resuming TVIX issuance and the sudden contraction of the premium. More recently, in July 2012, an investigation into fraudulent non-disclosure of some risks by Credit Suisse was initiated by Wohl & Fruchter LLP.

From an investor viewpoint, the important question is why positive premium built up in the first place. Firstly, the indicative value

of TVIX is published on a daily basis on the website of VelocityShares15 and can also be followed intra-day by the ticker TVIXIV. Thus, information about the accumulated premium was available to investors on a timely basis. Secondly, shorting TVIX was possible before and after the suspension of note issuance. Bloomberg reports that the number of shares sold short at the end of February 2012 was 4 million, up from 1.5 million at the end of 2011.16 The data on the short interest in Bloomberg reveals an increase to 6.86 million in mid March and then a further increase to 7.19 million shares sold short at the end of March. Finally, Figure 2 clearly shows that a leveraged exchange-traded product tracking the same index did not suffer from the same price distortion. Therefore, the reason cannot be related to the fact that the product is leveraged or that it is tracking a volatility futures index.

In fact the identical underlying exposure conceals a crucial difference between the nature of the two products. TVIX is an ETN while UVXY is an ETF. We point out differences between ETNs and ETFs in


14 - See the Bloomberg article “SEC Said to Review Credit Suisse VIX Note” published on March 29, 2012 and available online (http://www.bloomberg.com/news/2012-03-29/sec-said-to-review-credit-suisse-vix-note.html).15 - A table is available on the web-site (http://www.velocityshares.com/tvix). 16 - See the article available online on the web-site of Bloomberg (http://www.bloomberg.com/news/2012-03-23/credit-suisse-vix-note-tumbles-to-record-low-price.html).

Figure 2. The price of TVIX, its indicative value represented by the TVIXIV Index, and the price of UVXY scaled down to the price of TVIX at the beginning of 2012 (immediatly below). Both TVIX and UVXY track 2x S&P 500 VIX Short-Term Futures Index. The plot on the following page shows the premium of TVIX and UVXY as a percentage of their indicative values.



Section 3, which may provide an explanation for the market distortion. In the next section, we proceed with a description of the main investable products related to volatility, which, apart from explaining the main motives for seeking a volatility exposure, reveal concerns about potential spillover effects between markets and the efficacy of volatility exposure through an ETN.



3. Some Explanations of the TVIX Incident



The example in Figure 2 indicates that we can look for an explanation of the price distortion in the differences between ETNs and ETFs and, more precisely, in the share creation and the share redemption processes.

ETFs are open-ended investment funds traded on a stock exchange. Most of them represent passive instruments designed to track as closely as possible the performance of a financial index. ETFs are generally characterized by a transparent and fluid share creation process which ensures that the price of the ETF remains close to the indicative net asset value (NAV). Like any other exchange-traded product, the prices of ETFs are determined by the corresponding supply and demand. Thus, the price may deviate below or above the NAV. The indicative NAV is published intra-day and can be compared to the price of the ETF almost in real time. If an ETF appears to be undervalued compared to the NAV, then an arbitrageur can buy ETF units, redeem them at the custodian bank for the underlying securities and sell them on the market, realizing a profit. Alternatively, if an ETF is overvalued, an arbitrageur can buy the underlying securities on the market, redeem them for ETF units, and sell the ETF units on the market realizing a profit.

As long as this mechanism is not limited by any regulatory or liquidity constraints, the price of an ETF remains close to its NAV. These two simple strategies are not, however, applicable in the case of ETNs (see Wright et al. 2010). As mentioned before, providers of ETNs typically reserve the right to issue more shares of the security under the same terms in the original issue. For example, the corresponding

section in the prospectus of TVIX reads:17

“We may, from time to time, without notice to or the consent of the holders of the ETNs, create and issue additional securities having the same terms and conditions as the ETNs offered by this pricing supplement, and ranking on an equal basis with the ETNs in all respects. If there is substantial demand for the ETNs, we may issue additional ETNs frequently. We may sell additional ETNs of any series at different prices but we are under no obligation to issue or sell additional ETNs of any series at any time, and if we do sell additional ETNs of any series, we may limit or restrict such sales, and we may stop selling additional ETNs of such series at any time. If we stop selling additional ETNs, the trading price and liquidity of the ETNs could be materially and adversely affected.”

In contrast to ETFs, however, the creation process is controlled solely by the issuer, and although the intention is to maintain liquidity and ensure agreement between price and indicative value, the issuer is under no obligation to do so. Thus, in the absence of a mechanism for investors to create shares a positive premium may build up in situations in which the issuer is unable to provide liquidity.

As far as early redemption of shares is concerned, both ETNs and ETFs follow a similar process. Shares are redeemed by the issuer on condition that the investor provides contracts above some minimum number. In the case of TVIX, the minimum amount is 25,000 contracts.18

In line with the arguments above, it has been reported in the literature that prices


17 - Quoted from the pricing supplement No. VLS ETN-1/A14 to the Prospectus Supplement published on March 23, 2012, pp 57. 18 - See the pricing supplement No. VLS ETN-1/A14 to the Prospectus Supplement published on March 23, 2012. For additional general comments see Diavatopoulos et al. (2011).



of ETNs can significantly deviate from the indicative values creating a positive premium, see Wright at al (2010). Possible explanations of this phenomenon considered by Diavatopoulos et al. (2011) include (i) potential liquidity constraints in the ETN space, (ii) investors having information about future movements of the value of the underlying index, and (iii) inefficiencies in the ETN share creation process. Using a sample of 93 ETNs, Diavatopoulos et al. (2011) find that a positive premium is usually preceded by abnormally high returns of the underlying which is consistent with the hypothesis that the mispricing is caused by a combination of return-chasing investors and issues with the share creation process rather than by informed investors anticipating future price movements or liquidity constraints.

The conclusions by Diavatopoulos et al. (2011) are particularly relevant for the case of TVIX. Positive premiums started building up after Credit Suisse discontinued the share creation process at a time of high demand, which is consistent with the hypothesis that investors may have been speculating the equity bull market would come to an end

with an associated increase in volatility. The positive premium contracted significantly around the announcement that the share creation process may be resumed but has frequently exceeded 10% since the end of March 2012.

It is clear that the general problems with ETNs mean that the problems faced by TVIX may not be directly related to its underlying exposure, which is to a volatility futures index. To illustrate this point, it is useful to look at another example of pricing issues with an ETN—the iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ). It accumulated a significant positive premium in 2012 after its supply had been suspended earlier. A note issued by Barclays on May 18, 2012, warns investors that the ETN has been traded with a significant premium over the indicative value since the beginning of the year.19 Figure 3 shows the price of GAZ together with the indicative value represented by the GAZIV Index and the premium as a percentage of the indicative value. The divergence is quite substantial and much worse than the case of TVIX in both magnitude and duration.


19 - The press release issued by Barclays is available online (http://www.ipathetn.com/static/pdf/investor_guidance_press_release.pdf).

Figure 3. The price of GAZ and the GAZIV Index representing its indicative value (immediatly below) and the premium as a percentage of the indicative value (following page). The supply of GAZ was suspended on August 21, 2009 and since February 2012 a significant positive premium has started building up and has persisted for 5 months so far.



Going back to the case of TVIX, in the presence of a leveraged ETF tracking the same underlying index, a natural hedging strategy would be to sell short TVIX and buy long UVXY. As mentioned in Section 2, short selling of TVIX did intensify at the end of February and throughout March 2012, reaching volumes in excess of four times those of December 2011, which, however, proved insufficient to suppress the accumulation of positive premiums. A reason why TVIX could have been impossible to short sell even more intensively is the inability of investors to borrow the security. This intuition has been confirmed with practitioners from the industry and is also supported by opinions expressed in the public domain.20 Situations with a surge in demand subject to a limited or suspended supply can result in difficulties to borrow and, hence, sell short. Furthermore, there were indications of a short-squeeze as sophisticated market participants tried to short sell TVIX but had to cover the short positions in an increasing market. Pengelly (2012) reports that, according to market participants, the short-squeeze could have been caused by algorithmic trading. The paper outlines another approach to hedge TVIX – by using VIX futures.


20 - See, for example, the blogs “The TVIX short-squeeze” (http://soberlook.com/2012/03/tvix-short-squeeze.html) and also “Another ETN you should not be buying” (http://seekingalpha.com/article/768291-another-etn-you-shouldn-t-be-buying).


4. Other Issues with Volatility Products



Although not directly related to the crisis with TVIX, which can be argued to be more directly related to the features of ETNs than to issues with volatility investing, we would like to discuss other potential issues with volatility products that may have an impact on investors.

Concerns have been raised about a potential spillover effect from the volatility ETN market to the underlying VIX futures market materializing as a higher systemic risk on the volatility market because of the significant herding in times of significant market declines. For example, during the August 2011 crisis in Europe the number of VXX shares outstanding halved; see Alexander and Korovilas (2012b). This implies significant redemptions, which in turn could imply selling a significant quantity of VIX futures, which, because of the lack of cash-and-carry arbitrage connection with the underlying VIX index, may have an impact on the statistical connection between VIX futures and the VIX index under those market conditions, i.e. their tracking properties may be adversely affected. It is nevertheless difficult to predict the relative magnitude of such a sell-off because a part of the ETNs are hedged internally by inverse volatility ETN products. Nevertheless, assuming all shares outstanding of TVIX on February 15, 2012, need to be hedged through the VIX futures market, Pengelly (2012) reports that if the underlying index goes up/down two percentage points, then this would imply purchasing/selling close to 10% of the total volume in the front-month VIX futures on a busy trading day.

Through VIX ETNs, the investor's objective is to get leveraged long exposure to the

volatility of the S&P 500, which hinges on two assumptions: (i) the VIX index is a good proxy of the volatility of the S&P 500 and (ii) VIX futures generally track the VIX index well.

As far as (i) is concerned, the VIX index itself is derived from out-of-the-money call and put S&P500 index options. Although there is academic research indicating it has better forecasting properties than classical backward-looking volatility measures for the US market (see Shu and Zhang (2011) and the references therein), we recall that this is conditional on the existence of a liquid and properly functioning index option market. The impact of option liquidity on the implied volatility curve has been studied by Chou et al. (2011) and Grover and Thomas (2012), an impact that, although only indirectly related to VIX, clearly indicates the nature of the problem. Generally, this might be of lesser concern for the US but should a volatility futures and ETN markets develop rapidly elsewhere, investors may be at risk if the corresponding option-derived volatility index is not based on a solid index option market and may not, therefore, be fully representative of the corresponding market index volatility.

As far as (ii) is concerned, in Section 1.1 we noted that a connection between the futures price of VIX futures and the spot VIX index cannot be established through the classical arbitrage-free argumentation. The observed statistical connection is due to the persistence of volatility.

4. Other Issues with Volatility Products


Conclusions



Volatility ETNs provide an easy access for investors to constant maturity VIX futures portfolios which, in turn, provide a long exposure to equity market volatility as measured by the VIX index. One of the most popular products, the TVIX ETN, has gained significant media attention since late February 2012, after the issuer (Credit Suisse) had discontinued creating new shares. As a consequence, positive premiums started building up and creating a market distortion that resulted in significant losses for retail investors in late of March 2012, when the issuer implied that issuing new shares might resume.

Our 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 in times of a significant surge in demand the security may become unavailable for borrowing which limits short-selling activities.

Finally, we note 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 characterized by higher sensitivity to VIX but also higher roll-over costs.

Overall, investors in volatility ETNs thus 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.

Conclusions


References



• Alexander, C., and D. Korovilas, (2012a), Diversification of Equity with VIX Futures: Personal Views and Skewness Preference, available online.

• Alexander, C., and D. Korovilas, (2012b), Understanding ETNs on VIX Futures (April 22, 2012). Available at SSRN: http://ssrn.com/abstract=2043061or http://dx.doi.org/10.2139/ssrn.2043061

• Amenc, N., F. Ducoulombier, F. Goltz, and L. Tang, (2012), What are the Risks of European ETFs? EDHEC Risk Institute Publication, January 2012.

• Ang, A., R. Hodrick, Y. Xing, and X. Zhang (2006) The Cross-Section of Volatility and Expected Returns, Journal of Finance, 61(1): 259-299.

• Bakshi, G., and N. Kapadia, (2003), Delta-Hedged Gains and the Negative Market Volatility Risk Premium, Review of Financial Studies, 16(2): 527-566.

• Chou, R., Y-J Hsiao, Y-H Wang, and S-L Chung, (2011), The Impact of Liquidity on Option Prices, Journal of Futures Markets, 31(12): 1116-1141.

• Coval, J. and T. Shumway (2001), Expected Options Returns, Journal of Finance, 56 (3): 983–1009.

• Deng, G., C. McCann, and O. Wang (2012), Are VIX Futures ETPs Effective Hedges?, Available at SSRN: http://ssrn.com/abstract=2094624.

• Diavatopoulos, D., J. Felton, and C. Wright, (2011), The Indicative Value–Price Puzzle in ETNs: Liquidity Constraints, Information Signaling, or an Ineffective System for Share Creation?, Journal of the Investing, 20(3): 25-39.

• Goltz, F. and L. Tang, (2012), The EDHEC European ETF Survey 2011, EDHEC-Risk Institute Publication.

• Grover, R., and S. Thomas, (2012), Liquidity Considerations in Estimating Implied Volatility, Journal of Futures Markets, 32(8): 714-741.

• Guobuzaite, R. and L. Martellini, (2012), The Benefits of Volatility Derivatives in Equity Portfolio Management, EDHEC-Risk Institute Publication, May 2012.

• Hiatt, J, and C. Shalen, (2007), Exchange-traded Volatility: CBOE and CFE VIX and Variance Derivatives, In Volatility as an Asset Class Ed. Israel Nelken, pp 233-250, Risk Books.

• Lin, Y.-H., (2007), Pricing VIX Futures: Evidence from Integrated Physical and Risk-Neutral Probability measures, Journal of Futures Market, 27(12): 1175-1217.

• Mougeot, N., (2007), Second-Generation Volatility Prodicts, In Volatility as an Asset Class Ed. Israel Nelken, pp 185-232, Risk Books.

• Pengelly, M., (2012), The ETN That Grew Too Fast, Risk Magazine, available online at http://www.risk.net/risk-magazine/feature/2170072/etn-grew-fast.

• Shu, J. and Z. Zhang, (2012), Causality in the VIX futures market, Journal of Futures Markets, 32(1): 24–46.

References



• Wright, C., D. Diavatopoulos, and J. Felton, (2010), Exchange Traded Notes: An Introduction, Journal of Investing, 19, pp. 27-37.

References



References


About EDHEC-Risk Institute





The Choice of Asset Allocation and Risk ManagementEDHEC-Risk structures all of its research work around asset allocation and risk management. This issue corresponds to a genuine expectation from the market. On the one hand, the prevailing stock market situation in recent years has shown the limitations of diversification alone as a risk management technique and the usefulness of approaches based on dynamic portfolio allocation. On the other, the appearance of new asset classes (hedge funds, private equity, real assets), with risk profiles that are very different from those of the traditional investment universe, constitutes a new opportunity and challenge for the implementation of allocation in an asset management or asset-liability management context.

This strategic choice is applied to all of the Institute's research programmes, whether they involve proposing new methods of strategic allocation, which integrate the alternative class; taking extreme risks into account in portfolio construction; studying the usefulness of derivatives in implementing asset-liability management approaches; or orienting the concept of dynamic “core-satellite” investment management in the framework of absolute return or target-date funds.

Academic Excellence and Industry RelevanceIn an attempt to ensure that the research it carries out is truly applicable, EDHEC has implemented a dual validation system for the work of EDHEC-Risk. All research work must be part of a research programme, the relevance and goals of which have been validated from both an academic

and a business viewpoint by the Institute's advisory board. This board is made up of internationally recognised researchers, the Institute's business partners, and representatives of major international institutional investors. Management of the research programmes respects a rigorous validation process, which guarantees the scientific quality and the operational usefulness of the programmes.

Six research programmes have been conducted by the centre to date:• Asset allocation and alternative diversification• Style and performance analysis • Indices and benchmarking• Operational risks and performance• Asset allocation and derivative instruments• ALM and asset management

These programmes receive the support of a large number of financial companies. The results of the research programmes are disseminated through the EDHEC-Risk locations in Singapore, which was established at the invitation of the Monetary Authority of Singapore (MAS), the City of London in the United Kingdom, and Nice, France. In addition, it has a research team located in the United States.

EDHEC-Risk has developed a close partnership with a small number of sponsors within the framework of research chairs or major research projects:• Core-Satellite and ETF Investment, in partnership with Amundi ETF• Regulation and Institutional Investment, in partnership with AXA Investment Managers

Founded in 1906, EDHEC is one of the foremost

international business schools. Accredited by the three

main international academic organisations, EQUIS, AACSB,

and Association of MBAs, EDHEC has for a number of years

been pursuing a strategy of international excellence that led it to set up EDHEC-Risk in 2001.

With eighty-five professors, research engineers, and research

associates, EDHEC-Risk has the largest asset management

research team in Europe.




• Asset-Liability Management and Institutional Investment Management, in partnership with BNP Paribas Investment Partners• Risk and Regulation in the European Fund Management Industry, in partnership with CACEIS• Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation, in partnership with CME Group• Asset-Liability Management Techniques for Sovereign Wealth Fund Management, in partnership with Deutsche Bank• The Benefits of Volatility Derivatives in Equity Portfolio Management, in partnership with Eurex• Structured Products and Derivative Instruments, sponsored by the French Banking Federation (FBF)• Advanced Modelling for Alternative Investments, in partnership with Newedge Prime Brokerage• Advanced Investment Solutions for Liability Hedging for Inflation Risk, in partnership with Ontario Teachers’ Pension Plan• The Case for Inflation-Linked Corporate Bonds: Issuers’ and Investors’ Perspectives, in partnership with Rothschild & Cie• Solvency II Benchmarks, in partnership with Russell Investments• Structured Equity Investment Strategies for Long-Term Asian Investors, in partnership with Société Générale Corporate & Investment Banking

The philosophy of the Institute is to validate its work by publication in international academic journals, as well as to make it available to the sector through its position papers, published studies, and conferences.

Each year, EDHEC-Risk organises two conferences for professionals in order to present the results of its research, one in London (EDHEC-Risk Days – Europe) and one in Singapore (EDHEC-Risk Days – Asia), attracting more than 2,000 professional delegates.

EDHEC also provides professionals with access to its website, www.edhec-risk.com, which is entirely devoted to international asset management research. The website, which has more than 50,000 regular visitors, is aimed at professionals who wish to benefit from EDHEC’s analysis and expertise in the area of applied portfolio management research. Its monthly newsletter is distributed to more than 1,250,000 readers.

EDHEC-Risk Institute: Key Figures, 2010-2011

Nbr of permanent staff 85

Nbr of research associates 19

Nbr of affiliate professors 26

Overall budget €11,200,000

External financing €6,215,000

Nbr of conference delegates 1,850

Nbr of participants at EDHEC-Risk Indices & Benchmarks seminars 391

Nbr of participants at EDHEC-Risk Institute Risk Management seminars 419

Nbr of participants at EDHEC-Risk Institute Executive Education seminars 356




The EDHEC-Risk Institute PhD in FinanceThe EDHEC-Risk Institute PhD in Finance is designed for professionals who aspire to higher intellectual levels and aim to redefine the investment banking and asset management industries. It is offered in two tracks: a residential track for high-potential graduate students, who hold part-time positions at EDHEC, and an executive track for practitioners who keep their full-time jobs. Drawing its faculty from the world’s best universities and enjoying the support of the research centre with the greatest impact on the financial industry, the EDHEC-Risk Institute PhD in Finance creates an extraordinary platform for professional development and industry innovation.

Research for BusinessThe Institute’s activities have also given rise to executive education and research service offshoots. EDHEC-Risk's executive education programmes help investment professionals to upgrade their skills with advanced risk and asset management training across traditional and alternative classes. In partnership with CFA Institute, it has developed advanced seminars based on its research which are available to CFA charterholders and have been taking place since 2008 in New York, Singapore and London.

While EDHEC-Risk makes important publiccontributions to the advancement of applied financial research and the improvement of industry practices, the insights drawn from EDHEC-Risk’s “Indices & Benchmarking”, “ALM and Asset Management” and “Derivatives and Asset Management” research programmes over the past several years have led to a series of

indices and benchmarks that provide more efficient or more academic-based solutions to investors’ needs than current offers available on the market.


EDHEC-Risk Institute Publications and Position Papers

(2009-2012)




2012• Garcia, R., V. Le Sourd, and L. Martellini. Robust assessment of hedge fund performance through nonparametric discounting (June).

• Amenc, N., F. Goltz, V. Milhau, and M. Mukai. Reactions to the EDHEC study “Optimal design of corporate market debt programmes in the presence of interest-rate and inflation risks” (May).

• Goltz, F., L. Martellini, and S. Stoyanov. EDHEC-Risk equity volatility index: Methodology (May).

• Amenc, N., F. Goltz, M. Masayoshi, P. Narasimhan and L. Tang. EDHEC-Risk Asian index survey 2011 (May).

• Guobuzaite, R., and L. Martellini. The benefits of volatility derivatives in equity portfolio management (April).

• Amenc, N., F. Goltz, L. Tang, and V. Vaidyanathan. EDHEC-Risk North American index survey 2011 (March).

• Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, L. Martellini, and S. Sender. Introducing the EDHEC-Risk Solvency II Benchmarks – maximising the benefits of equity investments for insurance companies facing Solvency II constraints - Summary - (March).

• Schoeffler, P. Optimal market estimates of French office property performance (March).

• Le Sourd, V. Performance of socially responsible investment funds against an efficient SRI Index: The impact of benchmark choice when evaluating active managers – an update (March).

• Martellini, L., V. Milhau, and A.Tarelli. Dynamic investment strategies for corporate pension funds in the presence of sponsor risk (March).

• Goltz, F., and L. Tang. The EDHEC European ETF survey 2011 (March).

• Sender, S. Shifting towards hybrid pension systems: A European perspective (March).

• Blanc-Brude, F. Pension fund investment in social infrastructure (February).

• Ducoulombier, F., Lixia, L., and S. Stoyanov. What asset-liability management strategy for sovereign wealth funds? (February).

• Amenc, N., Cocquemas, F., and S. Sender. Shedding light on non-financial risks – a European survey (January).

• Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Ground Rules for the EDHEC-Risk Solvency II Benchmarks. (January).

• Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Introducing the EDHEC-Risk Solvency Benchmarks – Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints - Synthesis -. (January).

• Amenc, N., F. Cocquemas, R. Deguest, P. Foulquier, Martellini, L., and S. Sender. Introducing the EDHEC-Risk Solvency Benchmarks – Maximising the Benefits of Equity Investments for Insurance Companies facing Solvency II Constraints (January).

EDHEC-Risk Institute Publications (2009-2012)



• Schoeffler.P. Les estimateurs de marché optimaux de la performance de l’immobilier de bureaux en France (January).

2011• Amenc, N., F. Goltz, Martellini, L., and D. Sahoo. A long horizon perspective on thecross-sectional risk-return relationship in equity markets (December 2011).

• Amenc, N., F. Goltz, and L. Tang. EDHEC-Risk European index survey 2011 (October).

• Deguest,R., Martellini, L., and V. Milhau. Life-cycle investing in private wealth management (October).

• Amenc, N., F. Goltz, Martellini, L., and L. Tang. Improved beta? A comparison of index-

weighting schemes (September).

• Le Sourd, V. Performance of socially responsible investment funds against an Efficient SRI Index: The Impact of Benchmark Choice when Evaluating Active Managers (September).

• Charbit, E., Giraud J. R., F. Goltz, and L. Tang Capturing the market, value, or momentum premium with downside Risk Control: Dynamic Allocation strategies with exchange-traded funds (July).

• Scherer, B. An integrated approach to sovereign wealth risk management (June).

• Campani, C. H., and F. Goltz. A review of corporate bond indices: Construction principles, return heterogeneity, and fluctuations in risk exposures (June).

• Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions, and the rational pricing of liability streams (June).

• Amenc, N., F. Goltz, and S. Stoyanov. A post-crisis perspective on diversification for risk management (May).

• Amenc, N., F. Goltz, Martellini, L., and L. Tang. Improved beta? A comparison of index-weighting schemes (April).

• Amenc, N., F. Goltz, Martellini, L., and D. Sahoo. Is there a risk/return tradeoff across stocks? An answer from a long-horizon perspective (April).

• Sender, S. The elephant in the room: Accounting and sponsor risks in corporate pension plans (March).

• Martellini, L., and V. Milhau. Optimal design of corporate market debt programmes in the presence of interest-rate and inflation risks (February).

2010• Amenc, N., and S. Sender. The European fund management industry needs a better grasp of non-financial risks (December).

• Amenc, N., S, Focardi, F. Goltz, D. Schröder, and L. Tang. EDHEC-Risk European private wealth management survey (November).

• Amenc, N., F. Goltz, and L. Tang. Adoption of green investing by institutional investors: A European survey (November).




• Martellini, L., and V. Milhau. An integrated approach to asset-liability management: Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (November).

• Hitaj, A., L. Martellini, and G. Zambruno. Optimal hedge fund allocation with improved estimates for coskewness and cokurtosis parameters (October).

• Amenc, N., F. Goltz, L. Martellini, and V. Milhau. New frontiers in benchmarking and liability-driven investing (September).

• Martellini, L., and V. Milhau. From deterministic to stochastic life-cycle investing: Implications for the design of improved forms of target date funds (September).

• Martellini, L., and V. Milhau. Capital structure choices, pension fund allocation decisions and the rational pricing of liability streams (July).

• Sender, S. EDHEC survey of the asset and liability management practices of European pension funds (June).

• Goltz, F., A. Grigoriu, and L. Tang. The EDHEC European ETF survey 2010 (May).

• Martellini, L., and V. Milhau. Asset-liability management decisions for sovereign wealth funds (May).

• Amenc, N., and S. Sender. Are hedge-fund UCITS the cure-all? (March).

• Amenc, N., F. Goltz, and A. Grigoriu. Risk control through dynamic core-satellite portfolios of ETFs: Applications to absolute return funds and tactical asset allocation (January).

• Amenc, N., F. Goltz, and P. Retkowsky. Efficient indexation: An alternative to cap-weighted indices (January).

• Goltz, F., and V. Le Sourd. Does finance theory make the case for capitalisation-weighted indexing? (January).

2009• Sender, S. Reactions to an EDHEC study on the impact of regulatory constraints on the ALM of pension funds (October).

• Amenc, N., L. Martellini, V. Milhau, and V. Ziemann. Asset-liability management in private wealth management (September).

• Amenc, N., F. Goltz, A. Grigoriu, and D. Schroeder. The EDHEC European ETF survey (May).

• Sender, S. The European pension fund industry again beset by deficits (May).

• Martellini, L., and V. Milhau. Measuring the benefits of dynamic asset allocation strategies in the presence of liability constraints (March).

• Le Sourd, V. Hedge fund performance in 2008 (February).

• La gestion indicielle dans l'immobilier et l'indice EDHEC IEIF Immobilier d'Entreprise France (February).

• Real estate indexing and the EDHEC IEIF Commercial Property (France) Index (February).




• Amenc, N., L. Martellini, and S. Sender. Impact of regulations on the ALM of European pension funds (January).

• Goltz, F. A long road ahead for portfolio construction: Practitioners' views of an EDHEC survey. (January).




2012• Till, H. Who sank the boat? (June).

• Uppal, R. Financial Regulation (April).

• Amenc, N., F. Ducoulombier, F. Goltz, and L. Tang. What are the risks of European ETFs? (January).

2011• Amenc, N., and S. Sender. Response to ESMA consultation paper to implementing measures for the AIFMD (September).

• Uppal, R. A Short note on the Tobin Tax: The costs and benefits of a tax on financial transactions (July).

• Till, H. A review of the G20 meeting on agriculture: Addressing price volatility in the food markets (July).

2010• Amenc, N., and V. Le Sourd. The performance of socially responsible investment and sustainable development in France: An update after the financial crisis (September).

• Amenc, N., A. Chéron, S. Gregoir, and L. Martellini. Il faut préserver le Fonds de Réserve pour les Retraites (July).

• Amenc, N., P. Schoefler, and P. Lasserre. Organisation optimale de la liquidité des fonds d’investissement (March).

• Lioui, A. Spillover effects of counter-cyclical market regulation: Evidence from the 2008 ban on short sales (March).

2009• Till, H. Has there been excessive speculation in the US oil futures markets? (November).

• Amenc, N., and S. Sender. A welcome European Commission consultation on the UCITS depositary function, a hastily considered proposal (September).

• Sender, S. IAS 19: Penalising changes ahead (September).

• Amenc, N. Quelques réflexions sur la régulation de la gestion d'actifs (June).

• Giraud, J.-R. MiFID: One year on (May).

• Lioui, A. The undesirable effects of banning short sales (April).

• Gregoriou, G., and F.-S. Lhabitant. Madoff: A riot of red flags (January).

EDHEC-Risk Institute Position Papers (2009-2012)

For more information, please contact: Carolyn Essid on +33 493 187 824 or by e-mail to: [email protected]

EDHEC-Risk Institute393 promenade des AnglaisBP 311606202 Nice Cedex 3 — FranceTel: +33 (0)4 93 18 78 24

EDHEC Risk Institute—Europe10 Fleet Place - LudgateLondon EC4M 7RB - United KingdomTel: +44 207 871 6740

EDHEC Risk Institute—Asia1 George Street - #07-02Singapore 049145Tel.: +65 6438 0030

www.edhec-risk.com

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