Something was amiss when Erich Brehm checked his TVIX holdings
late last week.
The VelocityShares Daily 2x VIX Short-Term exchange-traded note,
which trades under the symbol TVIX, shed half its market value
between Thursday and Friday, a tumble that spooked investors and
underscored the complexities of easy-to-trade securities tied to
volatility.
"Something weird happened last week and the market value got cut
in half. It happened for some reason that none of us understand,"
said Brehm, 59, owner of a medical supply distribution business in
Sunnyvale, Texas, who said he bought 2,200 TVIX shares for $17.30
each back on Feb. 22.
On Wednesday, TVIX rose 15% to $8.02.
Last week's price crash capped a month of anomalous moves in the
TVIX after new issuance dried up.
Credit Suisse AG (CS), the bank that issues TVIX shares,
suspended new creation after a rush of demand. The suspension
prompted the price of TVIX to drift far from the basket of assets
it was meant to track. Prior to the temporary suspension, its price
tracked closely with its underlying index, which is tied to futures
on the Chicago Board Options Exchange Volatility Index.
In a two-sentence press release on Feb. 21, the bank said it
would cease to create new units of TVIX "due to internal limits on
the size of the ETNs." More than $640 million had flowed into the
fund during the first seven weeks of the year, up from just over
$100 million to start the year, according to global research and
advisory firm XTF.
The halt triggered a supply-demand imbalance.
Credit Suisse spokeswoman Katherine Herring declined to
comment.
"The fact that Credit Suisse stopped issuing the notes meant
that the tie with the net asset value was gone," said Ralph
Edwards, director of derivatives strategy at ITG, meaning that the
market price of TVIX drifted above intrinsic value, or higher than
where the price would be if shares could be created and
redeemed.
TVIX is packaged to deliver juiced-up returns for investors
looking to hedge against stock-portfolio declines. Its price is
meant to double daily returns on futures on the Chicago Board
Options Exchange Volatility Index, or VIX, and rise when stocks
fall. Over the last 12 months, the TVIX moved an average of 6.7%
daily in either direction. So far in 2012, the TVIX is down 75% so
far this year.
Many investors were both unaware that external forces were
influencing TVIX, and that an influx in new creations would likely
compress the price, which last week rose to nearly double its
intrinsic value. The ETN closed at $14.43 on March 21, 89% higher
than its $7.62 net asset value, according to FactSet Research.
A day later, on March 22, the TVIX dropped 29%, amid by heavy
short-selling activity. Short sellers borrow shares from other
investors and sell them in the hope of buying them back at a lower
price later.
The timing proved auspicious. Hours after the market closed on
Thursday, Credit Suisse said it would reopen new issuance of shares
the following day.
TVIX plunged another 30% on Friday, as additional supply weighed
down the market price of the ETN.
Data show that some investors started betting on an eventual
slide in TVIX immediately after creation was halted last month, and
that short-selling accelerated price declines.
"Short sellers immediately began borrowing hundreds of thousands
of shares to profit from the assumed eventual reversion to the
mean, or reduction in premium," said Andrew Shinn, director of
research at SunGard's Astec Analytics unit in New York.
Following last month's halt, the number of TVIX shares borrowed
by short sellers nearly quadrupled overnight, from nearly 600,000
on Feb. 21, to just over 2.2 million a day later, according to Data
Explorers. By March 22, the number of borrowed shares had jumped to
4.1 million.
Securities and Exchange Commission spokeswoman Florence Harmon
declined to comment on whether the SEC was looking into any unusual
trading of TVIX.
While frustration was widespread, the risks are outlined in the
fund's investment materials.
"The [net asset value] disengaged from the reality, and Credit
Suisse essentially turned it into a closed-end fund," said Bill
Singer, partner at the law firm Herskovits PLLC, noting that recent
TVIX performance appears to be consistent with the fund's
disclaimers.
"The market price of your ETNs may be influenced by many
unpredictable factors," including "supply and demand," according to
the TVIX prospectus.
For other volatility-linked products "there will be greater
scrutiny going forward," said Ryan Detrick, senior technical
strategist at Schaeffer's Investment Research.
"If you read the fine print, maybe a lot of people who were
trading this really shouldn't have," Detrick said. "The TVIX soured
a lot of people toward these instruments and there are a lot of
people who are still losing confidence in some of these more arcane
Wall Street instruments."
-By Chris Dieterich, Dow Jones Newswires; 212-416-2611;
christopher.dieterich@dowjones.com