Investors have been hungry for products that provide exposure to volatility. Which is why so many have flocked to a series of new exchange-traded notes and exchange-traded funds and promise to fit the bill. But earlier this year, investors in the TVIX ETN issued by Credit Suisse got a nasty surprise when the value started to plunge precipitously and seemingly inexplicably. In response, the EDHEC-Risk Institute has issued a new study called “The Risks of Volatility ETNs: a Recent Incident and Underlying Issues,” that is mean to shed light on the nature of volatility ETNs and the issues involved in the TVIX crisis.
The study finds that the problems with Credit Suisse’s volatility product were not a result of exposure to a volatility index, rather then stemmed from problems that are specific to ETFs. Specifically, the inefficient share creation process and speculative motives of uninformed, return-chasing investors. According to the study:
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.
The study also recommends that investors in volatility ETNS need to understand that the underlying index 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 that 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.