Deutsche Bank’s tracker notes tied to S&P 500 TR, ProVol to offer tactical play on volatility

By Emma Trincal

New York, Jan. 19 – As investors are watching stumbling oil prices and equity market declines, volatility bets are being considered again.

Deutsche Bank AG, London Branch is planning to use one of its popular proprietary indexes for the first time this year through 0% tracker notes due Feb. 23, 2018 linked to the S&P 500 Total Return index and the Deutsche Bank ProVol Balanced index.

The notes offer exposure to one times any increase or decrease in the level of the S&P 500 Total Return index and two times the return of the Deutsche Bank ProVol Balanced index both on the upside and the downside, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are popular among registered investment advisers, according to a market participant, who said that Deutsche Bank does not sell those products to broker-dealers.

Since the creation of the ProVol allocation model in Sept. 2012, Deutsche Bank has offered nine registered notes tied to a variety of ProVol indexes that use the methodology, according to data compiled by Prospect News. This will be the first one for this year.

Deutsche Bank has also offered to institutional clients through swaps some exposure to its ProVol model, the market participant said.

Desirable asset class

What makes volatility algorithms popular is the need to hedge a portfolio or to be long volatility without incurring too much of a cost, explained an industry source.

“Volatility is generally negatively correlated with equities or the S&P. The idea is to combine volatility and equity so that you get a better risk-adjusted return than just buying equity,” he said.

But ProVol does more than buying volatility, according to the market participant.

Challenge

“To be systematically long volatility can be expensive and to be systematically short carries the risk of spikes in volatility when the market crashes,” the market participant said.

“In response to these challenges, ProVol allocates to either long or short volatility based on market conditions.”

Realized volatility

The model uses three types of signals, according to an index guide published by Deutsche Bank.

The first one, called volatility regime, is based on realized volatility. The idea is not to buy too soon.

“Long volatility positions can be expensive especially if volatility is not high enough,” the market participant explained.

For this reason, the signal for a long position requires a high-volatility regime.

Timing, cost

The second indicator is implied volatility, which will dictate the price levels for long or short positions.

“If we are in a high volatility regime but the implied is still low, the signal generates a long position,” the market participant said.

That’s because the strategy aims to find early entry and exit points.

The third signal is the term structure of the futures curve, which determines the cost of rolling the contracts, or carry.

Cost is a function of the steepness of the forward curve. Positions are based on VIX futures contracts, which need to be rolled as they expire. If the curve is steep, rolling will be pricey as the proceeds obtained from selling the nearby contracts will be less than the cost of buying further, a situation detrimental for returns known as contango.

“You don’t want to be long too soon due to the cost of carry,” he said.

“The volatility curve tends to be steep which makes a systematically long position high cost. If the curve is upward slopping, it’s costly to be long. You’re more likely to be short in this case.”

The model combines all three signals to determine what positions to take and when.

“One of the main ideas is to avoid trading on false signals,” he said.

Holy Grail

But some are skeptical. The industry source was critical of volatility indexes in general.

“Many firms, not just Deutsche Bank, came out with their own version: UBS did it, Credit Suisse, Citi, Barclays. They all look for better ways to hold volatility without losing money in the cost of carry,” he said.

“We all know that when you’re buying vol and keep on rolling the futures, you lose long-term.

“The term structure is usually positive. You roll and you keep on buying at a higher price than spot.

“If you keep on doing it and do it consistently, most of the time you lose.

“It’s like insurance. You pay $1,000 in insurance premium each year. You do it for 100 years. But how often are you buying it just before the fire?”

“Deutsche Bank is doing its own thing to deal with this old problem. It’s hard to buy volatility. You want to buy it under certain circumstances. But it’s still not clear what’s the best way to do it.

“Each bank has its own secret sauce.

“All these strategies use signals.”

Patience

ProVol, however, offers a specific advantage: the model does nothing when the signals are not there.

“Most volatility indices are costly to carry,” said Steve Doucette, financial adviser with Proctor Financial, who invests in the ProVol index.

“ProVol is interesting because it doesn’t do anything if it doesn’t hit the signals.

“It will do nothing for a while and then it hits big. The 2008 performance was phenomenal.

According to an FWP filing with the SEC, ProVol Balanced index showed a retrospective performance of 76.1% return in 2008.

“It’s been through phases when it was flat. For example in 2013-14, ProVol sat out of the market because volatility was going back and forth,” the market participant said.

Doucette said the payoff was worth waiting for.

“For a minimum carry cost, you have a huge possibility of outperforming. A huge like no other,” he said.

“We’re not even in it right now. You don’t own it until the signal says you’re long.

“There is a fee. But we don’t care when it kicks in.”

The fee consists of an adjustment factor, which is 0.9975% plus 0.4% per year for the S&P index and 1% per year for the ProVol index, according to the prospectus for the upcoming notes.

Dangers

A bull market offers a good example of the benefits of “doing nothing,” the market participant said.

“In a six-year bull market you don’t want to hedge your equity portfolio long volatility, which is exactly what many people did. You don’t want to do anything. What hurts the returns is over-trading or trading on false signals and that’s what ProVol is designed to avoid.”

A second financial adviser said that he had “bad experiences” with banks’ proprietary indexes when it comes to volatility strategies.

“I can’t tell about the Deutsche Bank one. I don’t know it. But I won’t touch any of those things linked to volatility models. They’re horrible,” he said.

“With volatility, you really need a trend to be established. It takes time to be long volatility or short volatility. The reactivity of those models takes several days. So when volatility goes up and down with no particular trend you get whipsawed. We actually got killed. I won’t touch those products again.”

RIA origin

The market participant explained that the ability of ProVol to stop trading was one of its strengths.

“If volatility doesn’t go anywhere, if there are no clear signals, ProVol will not take any positions. It just sits. Investors still pay the fee. But there is no cost of carry,” he said.

“Others force the index to take a position, long when it can be expensive or short when it can be risky. Many other products do that. The ability to take no position in the absence of signals is definitely a distinguishing feature.”

The products using ProVol in combination with the S&P 500 index began with Deutsche Bank working closely with a client, he said.

“There was an awful lot of back and forth. That’s how the structure was put together.”

“Some investors use it to hedge. Some may sell a portion of their S&P allocation in their portfolio and reinvest it in the notes with two times the ProVol exposure,” he said.

“It can be one time, it can be two times.

“Those allocations depend on the client.”

The notes will price on Feb. 18 and settle on Feb. 23.

Deutsche Bank Securities Inc. is the agent.

The Cusip number is 25152RV75.

Another note with one-time exposure to both underlying indexes is set to price on the same day. Its Cusip number is 25152RV67.

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