How Two Small Volatility ETFs Triggered a Stock Market Correction
People are still scratching their heads as to why exactly the stock market experienced a 10% decline in early February after the best corporate earnings season in memory. Some are blaming the Federal Reserve’s January 31st policy statement, which mentioned increased inflation. Others point to the January employment numbers issued on February 2nd, which reported a 2.9% year-over-year hike in wages, the largest in more than eight years.
Neither explanation is convincing.
Short-term interest rates have been rising for two years starting with the first Fed hike in 2015. The last “dot plot” from the Fed at its December 13th meeting forecast three rate hikes in 2018, from the current 1.25% – 1.50% range to a 2.00% -2.25% range, so investors were already expecting higher rates. Inflation rising closer to the Fed’s target of 2% is actually a good thing since it ensures that the economic recovery is sustainable and corporate profits will continue to grow. An inflation “target,” after all, is something to be wished for, right?
It just does not make sense that strong corporate profits and inflation closer to the Fed’s desired target would explain the first 10% market correction in fi.
So what else does?
Volatility ETFs and ETNs Are the Culprit for the Market Correction
Believe it or not, my candidates for the primary cause of the stock-market market correction are two arcane exchange-traded volatility products called the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY).
An exchange-traded note (ETN) is a debt instrument (i.e., an I-O-U) where the issuer promises to pay the holder the return of a specified portfolio of securities without actually being required to own the portfolio. In contrast, an exchange-trade fund (ETF) actually owns a portfolio of securities and passes through the portfolio’s return to the holder (minus fees, of course). Although ETNs and ETFs are different, they are close enough that I will refer to them collectively as exchange-traded products (ETPs).
Don’t bother looking up the ticker for XIV because it no longer trades. Credit Suisse (NYSE: CS), the issuer of XIV, shut down the security after it collapsed from an all-time high price of $146.44 on January 11th to a closing price of $6.04 on February 15th.
In case you don’t fully grasp what I just wrote, let me rephrase: a security that loses 96% of its value in one month is a bad thing.
What are Volatility ETPs?
First things first: the value of these two ETPs are based on selling S&P 500 volatility futures, also known as VIX futures. The symbol VIX stands for “volatility index.” VIX futures are financial commodities traded at the Chicago Board Options Exchange (CBOE) that measure the expected percentage change in the price of the S&P 500 index over a 30-day period. Because futures have a fixed expiration date, one needs to buy a combination of two different VIX futures contracts that is constantly adjusted on a day-by-day basis to maintain a constant blended maturity date of exactly 30 days.
The expected price move is derived from option prices on the S&P 500, with higher option prices reflecting higher volatility expectations and lower option prices reflecting lower volatility expectations. When you think about it, the main reason one buys an option is because they will make a profit if the underlying security that the option is based on makes a large price move. It makes sense that options cost more if the expected price move is greater.
If you are confused by this definition of volatility ETPs, join the club. Volatility ETPs are not easy to understand, which makes their widespread usage by average retail investors quite worrisome. Adding to the confusion are recent accusations that VIX prices are rigged. You should always fully understand what you are investing in!
Increased Regulation of Volatility ETPs is on the Horizon
After the February 6th collapse of XIV, the Securities & Exchange Commission (SEC) is finally getting concerned after the fact (what else is new?) and has started an investigation of volatility ETPs and their suitability for retail investors. Not waiting for this investigation to proceeding, some volatility ETP issuers are taking unilateral action to reduce risk.
For example, on February 27th ProShares reduced the leverage of two of its volatility ETPs:
- UVXY, which moves in the same direction as S&P 500 volatility futures, had its leverage change from two-times to only 1.5 times. In other words, instead of moving 10% if volatility futures move 5%, UVXY will move only 7.5%.
- SVXY, which moves opposite to volatility, now moves only half the inverse of the percentage change in volatility futures instead of one-for-one.
The Options Clearing Corporation ruled that the strikes on UVXY and SVXY options will not be adjusted despite the fact that the unanticipated reduction in leverage materially reduces the value of the options. The decision is good for option sellers and bad for option buyers.
Short Selling is Much More Dangerous Than Going Long
I especially understand ProShares decision to reduce leverage for the inverse SVXY because short selling anything is dangerous. When buying a security, the risk of total loss only occurs if the underlying price goes to zero, which never happens in the case of volatility (the lowest the VIX has ever reached is 8.56 on November 24th 2017) whereas total loss can occur on a short sale if the underlying price merely doubles. On February 5th, the VIX rose 116%, more than doubling from 17.31 to 37.32. The largest one-day percentage gain prior to that day was only 64% in February 2007.
Fortunately for owners of XIV and SVXY (relatively speaking), VIX futures are less volatile than the “spot” VIX, so the futures did not double and neither volatility ETP lost 100% of its value, but 96% is pretty close to worthless. And since XIV is an ETN, Credit Suisse granted itself the power as a debt issuer to terminate the product if it lost 80% or more of its value in one day, which gave the holders no chance to recoup their losses. ProShares’ SVXY continues to trade since it is an ETF, but now that its leverage is only 0.5 instead of one-for-one, loss recoupment will take much longer to occur, assuming it does at all. As I wrote in The Great Investment Truth Behind Simple Arithmetic, large losses are much more difficult to recoup than small losses. In the case of SVXY, a 90% loss requires a 900% gain just to break even. Good luck.
Making matters worse is the fact that Credit Suisse and ProShares perform their daily rebalance of VIX futures after the market close when trading volume and liquidity are much lower, which magnified the upward price move on VIX futures caused by their rebalancing buy orders. Everybody knows this. Since hedge funds knew that Credit Suisse and ProShares would need to rebalance big-time after the market close, many engaged in front-running, buying VIX futures prior to the market close on February 5th in anticipation of selling them back at higher prices to these two hapless ETP issuers after the market close. All of this activity made the price spike in VIX futures worse.
How a Small Ripple in a Pond Became a Giant Market Tsunami
Despite the carnage in this niche area of volatility ETPs, the fact remains that the total assets invested in these products was a relatively minuscule $3.6 billion, which is nothing compared to $23 trillion market cap of the S&P 500 index. Yet, there are cases where the tail wags the dog instead of vice-versa and this is one of those instances.
A “ripple effect” is defined as:
A spreading, pervasive, and usually unintentional effect or influence.
All it took was a small uptick in volatility to spark a mass panic among leveraged investors and issuers of these volatility ETPs, which forced some of these ETP holders to raise liquidity by selling stocks, which caused a downdraft in stock prices, which worried more stock investors who bought S&P 500 puts as insurance, which raised volatility even further . . . and the negative feedback loop snowballed.
Next week, I will explain how option spreads can be used to trade volatility in a much safer manner than is possible from buying volatility ETPs.