The Securities Litigation Expert Blog

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

For information about securities expert Jack Duval, click here.

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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

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