VIX ETN VZZ Reincarnated as VZZB

07/12/2011 8:00 am EST

Focus: ETFS

Michael Johnston

Co-Founder and Senior Analyst, ETF Database

The leveraged ETN VZZ, which offered 2x returns to mid-term futures contracts, has been terminated, and a similarly structured ETN, VZZB, has been created to take its place.

Monday (July 11) marked the first day of trading for the iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN (VZZB), a new exchange traded note (ETN) that will offer leveraged exposure to an index comprised of mid-term VIX futures.

The underlying volatility benchmark consists of four-, five-, six- and seven-month futures contracts on the CBOE Volatility Index (VIX), and VZZB will deliver returns that correspond to the 2x leveraged return of that benchmark over the life of the note. Unlike ETFs that may operate indefinitely, exchange-traded notes are debt instruments that feature predetermined maturity dates. VZZB will mature in July 2021.

If VZZB sounds familiar, that’s because it is essentially a resurrection of VZZ, which shut down earlier this month after the automatic termination threshold was hit. Holders of VZZ were scheduled to receive their automatic termination distribution ($10 per share) on Monday as well.

VZZ shut down because the intraday indicative note value fell below 33.33% of the original per-ETN principal amount. After debuting at $30 in late 2010, VZZ had dropped below $10 on July 1 after a quarter-ending equity market rally sent volatility indexes tumbling to levels well below their long-term averages.

VZZB will maintain a similar automatic redemption feature; if the price drops below $10 per share, Barclays will automatically redeem the notes.

VZZB in Focus

The new ETN will offer exposure to futures linked to the VIX index, a widely followed benchmark that reflects expectations for short-term volatility in US equity markets (specifically, the S&P 500).

Because the VIX tends to rise whenever concerns over the health of the US economy intensify, volatility has become appealing as an asset class to some investors thanks to the strong negative correlation with stocks.

While a direct investment in the VIX isn’t possible, innovations in recent years have made it possible for investors to gain exposure to the “fear index” through futures contracts.

The index to which VZZB is linked will consist of mid-term VIX futures contracts—those maturing in four to seven months. That can mean a big difference relative to benchmarks consisting of VIX futures that are closer to expiration.

Generally, mid-term VIX futures won’t be as vulnerable to the adverse impact of “contango” as their short-term counterparts; contango is generally steepest at the short end of the maturity curve.

The tradeoff comes in the form of diminished sensitivity to changes in the spot VIX. When that benchmark jumps, short-term futures tend to gain more than their longer-term counterparts.

NEXT: Nuances of “Lifetime Leverage”


Nuances of “Lifetime Leverage”

VZZB will offer 2x leverage to the underlying index over the lifetime of the note—or about ten years. That type of leverage differs from the vast majority of leveraged ETFs, which reset exposure on a daily basis (the exposure offered by VZZB will never reset).

The result is that the effective leverage offered (meaning the amplification that can be expected if the note is held until maturity) will likely deviate from 2.0. When VZZ triggered its automatic redemption, the participation ratio (which is essentially the effective leverage multiple) had climbed to about 3.5, so it’s important for any investor considering VZZB to take a close look at that metric and understand the degree of volatility that can be expected in various environments.

“Our leveraged and inverse ETNs are designed with a leverage factor that is locked in at the point of purchase, reflecting returns that more closely track the index without path dependency over periods longer than a single trading day,” said Johnny Wu, head of Investor Solutions, Americas at Barclays Capital. “The launch today demonstrates our ongoing commitment to providing investors with efficient access to the US volatility markets without tracking error or resets.”

A look at some of the existing leveraged ETNs from iPath helps to understand exactly how this nuance in the product structure translates into risk/return profile.

Because equity benchmarks such as the Russell 1000, Russell 2000, and S&P 500 have performed relatively well since the below products debuted, the participation ratio of the long ETNs has declined from the original level of 3.0.

Among the short products, however, the participation ratio has skyrocketed. The iPath Short Extended Russell 2000 Index Total Return Index ETN (RTSA), for example, was recently offering leverage of greater than 8x (inverse) on the Russell 2000.

VelocityShares offers a product that is generally similar in some ways and very different in others. The VelocityShares Daily 2x VIX Medium-Term ETN (TVIZ) offers 2x leveraged exposure to the same index underlying VZZB, but resets exposure on a daily basis. The effective leverage offered will deviate from 2x throughout the course of a single trading day, but at the end of the session, the exposure will reset.

As always, be very careful when trading leveraged ETFs. Positions can move against (or for) you very quickly.

See related: The Leveraged ETF Safety Kit

By Michael Johnston of

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