TVIX: a Rock and a Hard Place

03/23/2012 12:56 pm EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

If you’re speculating on an imminent market crisis, you’re in pretty lousy company, writes senior editor Igor Greenwald.

Investors spend a lot of time trying to figure out what the smart money is doing. We scrutinize insider transactions, hedge-fund disclosure forms, and the oracular pronouncements of Warren Buffett in hopes of piggybacking on other people’s smarts, research, and inside knowledge.

But if following smart money is really so useful (I’m pretty skeptical, but also guilty as charged), then following dumb money ought to be equally informative. And, thanks to Thursday’s blowup in a leveraged exchange traded note, we know exactly what’s recently caught the fancy of the least savvy traders out there.

The VelocityShares Daily 2x VIX Short-Term ETN (TVIX) plunged 29% yesterday, even as the CBOE Volatility Index, whose movements it’s supposed to exaggerate, rose 3.6%. TVIX is down a further 28% today.

What happened was that Credit Suisse (CS), the backer of TVIX, suspended the creation of new shares on February 21, citing “internal limits on the size of the ETNs.” Apparently, the heavy flows into the instrument ran up against Credit Suisse’s internal risk controls. According to Bloomberg News, the issuance of new shares was suspended after the asset base had quadrupled this year.

The traders piling into TVIX were counting on this year’s market rally to roll over at any moment, setting off another bout of market volatility so prevalent last year, and enriching them in the process.

Once issuance of new shares was suspended, the TVIX became divorced from the underlying indexâ€"the VIXâ€"it was designed to track. At that point, it became a play not on the VIX itself, but on buyers’ perceptions of what the VIX might do in the future.

Credit Suisse warned this would happen when it stopped issuing shares: “…it’s possible that the temporary [emphasis added] of further issuances may cause an imbalance of supply an demand in the secondary market for the ETNs, which may cause the ETNs to trade at a premium or discount to their indicative value.”

And, indeed, this happened. Even as the rally never rolled over, even as TVIX kept losing value, it lost less value than the movements of the VIX dictated, because traders kept piling in with hopes for an imminent spike in volatility, and Credit Suisse was no longer issuing new shares to offset that speculative interest.

At that point, any sensible holder of TVIX ought to have bailed, because Credit Suisse had already indicated it would resume issuance at some point, and that any premium over indicative value (i.e., the price TVIX would have had had issuance not been halted) would evaporate.

Unfortunately, the holders of TVIX and the buyers of TVIX at a fat premium were almost by definition not sensible. According to Bloomberg, they blew out the premium over indicative value to a record 36% on March 16, and then 62%, 78%, and 89% over the next three days.

When the market caught wind of the fact that Credit Suisse would resume issuing new shares, sellers promptly unwound the accumulated premium. There are legitimate questions about how the information leaked into the market in the morning ahead of the evening announcement, and whether Credit Suisse and the Securities and Exchange Commission’s rule-makers did enough to prevent the speculative pop and subsequent crash.

But I’m more interested in the fact that we had a speculative mini-bubble this month in bets that market volatility would soar, after the relentless calm of January and February. It’s notable that the final surge in the premium of the traded TVIX over its underlying value began on March 16, because that was the date on which the VIX reached its lowest point since 2007.

Dumb money was clearly speculating on an imminent reversion to the mean of recent years, whereas in fact volatility may be reverting to the longer-term mean near its current levels.

The interest, by the way, is not confined to the TVIX. Once issuance of new shares was suspended, many traders simply moved over to the similarly leveraged ProShares Ultra VIX Short-Term Futures ETF (UVXY).

According to Bloomberg, UVXY’s assets jumped 13-fold between February 21 and March 16. This ETF, too, still trades at a (more modest) premium to net asset value.

So there you have it: the least savvy traders in captivity are still speculating on an imminent market crisis. Invest accordingly.

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