By Jared Dillian
(Bloomberg View) --The standard response to the collapse -- and in some cases, the liquidation -- of inverse volatility exchange-traded products has been, “Why the heck do we need these things?”
It’s a reasonable question. The problem with ETFs is that many of them appeal to retail investors, but are really meant for institutions. The VelocityShares Daily Inverse VIX Short-Term ETN, better known by as XIV, and the ProShares Short VIX Short-Term Futures, or SVXY, are examples. Shorting volatility isn’t supposed to be easy. In the old days, you had to actually sell options and dynamically hedge them. It involved some computer software and low transactions costs -- which were not typically available to retail investors.
There really is no rhyme or reason to the financial products the U.S. Securities and Exchange Commission allows people to trade. Plain-vanilla currency forwards are off limits to all except ultra high-net-worth individuals, and yet retail investors can trade a debt security product comprised of swaps layered on futures based on an index of options. Oh, and hedge funds that -- gasp -- short stocks are also too dangerous for small investors. I just don’t get it.
Let’s be clear: XIV and SVXY did exactly what they were supposed to do. If investors had read the prospectuses, there would not have been any surprises. It was clear that under certain circumstances that were not out of the realm of possibility that these things could go to zero. But not many people read prospectuses. Caveat emptor? Or should people be protected from their own worst instincts?
For years, the SEC has taken the former approach. I have lamented that leveraged ETFs (which seem plain vanilla compared with XIV) were too mathematically complex for retail investors to understand, and the risks (including autocorrelation, also disclosed in the prospectus) were nontransparent and caused the ETFs to fail the suitability test. The same could be said of XIV. For sure, there were big boys who lost money, but the vast majority of retail investors did not understand the risks. It was a huge wealth transfer from the unsophisticated to the sophisticated.
There are real economic reasons why people want exposure to volatility: It improves the risk characteristics of portfolios and it’s a terrific hedge. But more importantly, credit traders often use it to hedge their exposure to spread risk. The vol complex is not just a giant casino, or at least, it didn’t start out that way.
The securitization of volatility began with futures on the Chicago Board Options Exchange Volatility Index, or VIX, then with VIX options, and then with the first volatility ETF: the iPath S&P 500 VIX Short-Term Futures ETN, or VXX. Back in 2004, when I was an ETF trader at Lehman Brothers, we dreamed up the idea of a VIX ETF. Wouldn't it be cool, we thought, if you could buy and sell volatility like a stock? One of my colleagues went on to participate in the creation of that first volatility exchange-traded note.
But VXX didn’t quite behave quite like people thought a VIX ETF should behave. It went down all the time. If you think about it, this makes sense: Options decay, and if you hold an ETF that is based on an index of options, it will lose value over time. And so, VXX lost more than 99 percent of its value over time, with several reverse splits along the way. Some people got angry at VXX, but it did exactly what it was supposed to do. It bought VIX futures and rolled them to the next month, and with an upward-sloping term structure of volatility, it incurred huge amounts of negative carry in the process
The inverse volatility ETNs were created as sort of a response to VXX: If a long volatility product lost money constantly over time, would a short-volatility product mint gold coins? In fact, it did. Volatility veterans know that is the nature of short-volatility strategies -- you make money for five to 10 years and then you give back all the gains in one day in a giant tsunami. Less sophisticated people never bothered to learn the years of option theory, and saw a ticker that went up every day.
No one really cares if Richie Rich blows himself up, but we care very deeply if those on the edge of what constitutes financial viability lose money they can’t afford to lose. We have to take a long, hard look at this. The more exotic a structured product is, the greater the likelihood unsophisticated people are going to get burned.
It’s time the folks at the SEC and elsewhere in government sat around a conference table, ordered some pizza and did a little brainstorming about ways to protect these investors while perhaps liberating others. The current system is just not working.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World."
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