Velocity Shares Daily Inverse VIX Short-Term ETN’s ‘blow-up’ was to be expected, analyst says

By Emma Trincal

New York, Feb. 6 – Credit Suisse AG’s announcement on Tuesday of the termination of the Velocity Shares Daily Inverse VIX Short Term ETN (“XIV”) should not be a surprise, as the underlying strategy was “way too crowded,” said a market strategist.

Biggest intraday spike

Velocity Shares Daily Inverse VIX Short Term ETN succumbed to the biggest CBOE Volatility index intraday spike in history on Monday, noted Brett Manning, senior market analyst at Brifing.com. The VIX index moved up more than 143% from 16 to 39 intraday.

“If you’re a small investor or a small shop this could be a death blow,” said Donald McCoy, financial adviser at Planners Financial Services.

“It’s like planning for a 100-year flood and being hit by a 1,000-year tsunami.”

While the VIX is still not that high (it hit its highest level ever in 2008 at 97), Monday’s price move was the sharpest on record, said Manning.

The notes are being called due to an acceleration even triggered by an increase of more than 80% in a day of the underlying futures contracts, as disclosed in the prospectus.

Complacency

“This is the bursting of a one-way crowded trade, the short-volatility trade,” said Manning, who added that back in August he had already warned in a research note that short-volatility trades “look to be the on true bubble building right now.”

One factor that made him anticipate a bubble burst as early as last summer had to do with how investors gain exposure to volatility.

When investors short the VIX, he explained, they are not exposed to the index but to the underlying futures contracts.

Those contracts are rolled from one month to another. Such roll can either generate a positive return (positive roll yield) or a cost, which erodes returns, depending on the difference in price between spot or short-term futures contracts and longer-dated ones.

The futures curve is known to be in contango when spot prices are lower than longer-dated contracts, which generates a negative roll yield.

Being long the futures curve when it’s in contango increases the cost of rolling. But it is the opposite when the strategy is short.

Contango

“VIX futures are always in contango. If you’re short you’re rolling gains. It’s the perfect trade,” he said.

So perfect that the strategy became some sort of popular recipe for too many investors.

“Everybody levered up on this game. Retail market went in with ETFs and ETNs and it became more crowded than ever,” he said.

"It’s what caused the selloff in my view. When you have such a massive one-way crowded trade, it’s going to blow up. It was almost guaranteed to happen. People got caught into this idea they could obtain a guaranteed return via the rolling mechanism.”

Short squeeze

The second component to Monday’s spike was the need for protection. The big January rally caused investors who had harvested gains to start looking for hedges, pushing up volatility.

“After the break-out in 10-year Treasury yields last week, the strong job report on Friday, people became a little bit more concerned about inflation creating this selloff. Ironically it was triggered by growth unlike fear of an economic depression like in 2008. And what do you do when you have huge gains? People short the VIX began to hedge,” he said.

Short-sellers of volatility when “hedging” their position become long the VIX.

“As soon as the VIX started to rise people were trapped in that one-way trade.”

Just as the “crowded one-way trade” was a factor driving the selloff, a continuation of the unwinding short VIX trade could create a vicious cycle, he said.

Traders or investors?

“These ETNs have become so big, when they start to unwind they start to move the VIX,” he said.

Those strategies are still not mainstream, noted a registered investment adviser.

While VIX-related ETNs are believed to be very popular, most RIAs tend to stay away from making those long or short bets.

These products are for hedge funds or day traders,” said Tom Balcom, founder of 1650 Wealth Management.

“It’s not something we do ourselves for our clients.

“If the VIX is low or down you make huge gains. But if it spikes you lose your shirt.”

Short is now smart

While the ETN’s liquidation may make for negative headlines and cause regulators’ scrutiny, it may not spell the end of the strategy.

A lot of the “bleeding” may have already happened. For contrarians, or at least investors who do not see in the recent selloff anything more than an overdue and healthy correction, resuming the trade may make sense, he said.

“[Credit Suisse] probably had no choice but to call it. Interestingly it may be a much better trade now because it’s no longer crowded and the bubble has burst,” Manning said.

The trade may be much better because expectations of guaranteed gains have now vanished.

“The Dow was up 500 points today. For a new investor who doesn’t believe we’re really entering a period of higher volatility, it might be a reasonable trade.”

Credit Suisse AG in its announcement said the redemption notice will be issued by Feb. 15 with an acceleration date set for Feb. 21.

The last day of trading for the notes is expected to be Feb. 20.

The notes (Cusip: 22542D795) are linked to the S&P 500 VIX Short-Term Futures index.

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