UBS' E-Tracs Daily Long-Short VIX exchange-traded notes provide another twist on volatility

By Emma Trincal

New York, Dec. 2 - UBS AG, Jersey Branch's new UBS E-Tracs Daily Long-Short VIX exchange-traded notes are the first ETNs that let investors bet on the term structure of the volatility curve, according to a market participant.

The VIX, or CBOE Volatility index, measures the implied volatility of the S&P 500 index.

The UBS E-Tracs give investors "a cost-efficient way to capitalize on the steepness of the short end of the volatility market," Christopher Yeagley, UBS managing director and U.S. head of equity structured products, said in a company news release.

The underlying index is a composite index that measures the return from taking a long position in the S&P 500 VIX Mid-Term Futures Index Excess Return with a 100% weight and taking a short position in the S&P 500 VIX Short-Term Futures Index Excess Return with a 50% weight. The weights of the long and short positions are rebalanced daily.

The ETNs began trading Wednesday on NYSE Arca under the ticker symbol "XVIX."

The notes are designed for "sophisticated investors" only and not for "buy-and-hold investors", according to the prospectus.

"This is definitely not a retail product," the market participant said.

So far there has been only one product pursuing the same strategy, but it was a regular note, not an ETN, this source said.

In October, Barclays Bank plc priced $6 million of 0% notes due Oct. 11, 2013 based on the S&P 500 VIX Short-Term Futures Index Excess Return and the S&P 500 VIX Mid-Term Futures Index Excess Return.

Those notes are linked to a portfolio that has a long position of 70% in the mid-term index and a short position of 30% in the short-term index.

In both products, though, the idea is the same: to capitalize on taking positions at various points along the volatility forward curve, with investors being short the short end of the curve and long the middle.

Eliminating beta

But aside from their different format, there are differences between the two products, the market participant said. He said the long and short weights are designed to reflect differences in volatility between short- and mid-term futures contracts.

"The short-term VIX is two times as volatile as the mid-term VIX," he said.

"That's why the E-Tracs give investors a 100% long exposure to the mid-term VIX index and a 50% exposure to the short-term. It's a two to one.

The short-term VIX is based on the first- and second-month VIX futures contracts. The mid-term index reflects positions in the fourth-, fifth-, sixth- and seventh-month futures contracts.

"The two-month VIX futures are very expensive, but as they get close to maturity, they become cheaper regardless of what the VIX is doing," he said.

"This is really a contango issue, and the notes address the steepness of the term structure."

He offered the following example: Assuming a 5% increase in the VIX, the short-term VIX index would go up by 5% while the mid-term index would only rise by 2.5%.

"This is a way to hedge exposure to the VIX. By doubling up the mid-term exposure, you cancel out the VIX beta and have a pure exposure to the steepness of the term structure," the market participant said.

"While most VIX products deliver VIX beta by taking directional bets on the VIX, this one really delivers VIX alpha. You don't bet on the direction of the VIX. You're hedging the VIX."

'Not an equity hedge'

Although many volatility products are becoming available to investors, most focus on hedging an equity portfolio, this source said.

"They take a long position on the VIX in order to hedge a long equity position. But that's not what this product does. This is not an equity hedge," he said.

Volatility and equities have an inverse relationship. Investors have been drawn into buying products giving them long exposure to volatility as a way to reduce their losses when the performance of their stocks decline.

The new ETNs do not offer an equity hedge, but their creation was facilitated by the abundance of products that aim to do just that, the market participant said.

"VIX strategies are becoming incredibly popular. The increase in investors making directional bets on the VIX in order to hedge equity contributed to the steepness of the curve because they've been buying primarily the short-term VIX, which is the most volatile," he said.

So far, investors who wanted to capitalize on the steepness of the short end of the volatility market had to do it themselves, he said.

"It can be done. You need to be long $100 in the VXZ and short $50 in the VXX," he said.

The VXZ is Barclays' iPath S&P 500 VIX Mid-Term Futures ETN. The VXX is the iPath S&P 500 VIX Short-Term Futures ETN.

"The E-Tracs wrap this trade into one ETN," he said. "It just makes it more convenient."

One of a kind

Other volatility products have recently been introduced in the market, but aside from the term structure Barclays notes, none of them so far has allowed investors to bet on the steepness of short-term volatility, this source said.

Deutsche Bank AG, London Branch offers notes linked to the Deutsche Bank Equity Mean Reversion Alpha index, or Emerald index. This index capitalizes on a strategy that buys daily volatility and sells weekly volatility. The trade is based on the view that historically, volatility has been rising more than weekly volatility.

Barclays has an ETN linked to the S&P 500 Dynamic Veqtor index. The index gives investors broad equity market exposure with an implied volatility hedge by dynamically allocating to three components: equity, volatility and cash.

Citigroup Funding Inc.'s C-Tracs ETNs linked to the Citi Volatility Index Total Return give investors a long exposure to the third- and fourth-month futures contracts on the VIX with a short exposure to the S&P 500.

Finally, Credit Suisse AG, Nassau Branch's recently launched VelocityShares ETNs offer long, short or leveraged exposure to either the VIX short-term index or the VIX mid-term index in six different series.

Not for everyone

A financial adviser said that he would have to look at the new E-Tracs more closely in order to decide whether he would consider the product or not.

"It may be interesting, but I would have to understand how this underlying correlates with other asset classes and with my equity portfolio in particular," said Steve Doucette, financial adviser at Proctor Financial.

"We did the Emerald product, and it looked much simpler to me.

"It's based on the idea that when volatility goes up, daily volatility will rise more than weekly volatility. And that's a relationship that has been verified 70% of the time. All you do is capture the spread.

"If it's not a directional bet on volatility and if the fees are not too high, I may look at it."

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