Plunge in volatility product a warning to investors

NEW YORK Mon Mar 26, 2012 9:13am EDT

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NEW YORK (Reuters) - After losing more than half of its value in the past two days, the plunge in the TVIX volatility-linked exchange-traded product should serve as a warning to investors before jumping into these high risk, esoteric products.

The VelocityShares Daily 2x VIX Short-Term exchange-traded note fell nearly 30 percent on Friday, following a 30 percent decline on Thursday. New share issuance of this ETN was halted a month ago as investors scrambled into this and other volatility-linked securities to bet on an increase in more market gyrations down the road.

The decline started on Wednesday, when speculation began that Credit Suisse, the issuer, would reopen issuance of the ETN on a limited basis. Credit Suisse announced a few hours after Thursday's close of trading that it would resume issuing new shares.

The price decline is not a surprise - the ETN's price had diverged from its underlying net asset value as a result of the halt in share issuance, so the move could have been predicted.

But the swiftness of the move caught investors by surprise, and analysts had warned that this product - as well as others - are not designed for long-term holding.

"Buyers of TVIX were uninformed. There was no reason to buy TVIX when it was trading at such a premium... They were all caught off-guard when it started dropping in price later in the week," said TABB Group analyst Henry Chien.

More than 30 million shares in TVIX traded on Thursday and more than 27 million on Friday, making it about as active as liquid stocks like Citigroup and Microsoft.

"For end-users of volatility products in general, they should be careful and educate themselves on the mechanics of the product, because something like this could happen again."

Investors had flocked to products that bet on or hedge against volatility in recent months on concerns that the market rally - which has continued nearly unabated since December - would not be sustained. However, some investors started to hold the products - intended for short-term hedges - for long periods, exposing themselves to losses due to the product's structure.

"I assure you that there are a lot of people who owned TVIX and lost a lot of money without understanding why," said Larry McMillan, president of McMillan Analysis Corp., in a report to clients issued Friday, referring to Thursday's action.

Whether the new shares were actually issued on Friday were unknown as Credit Suisse declined to comment. The company also declined to comment on what "limited basis" meant.

Credit Suisse stopped issuing shares in the product in February when investors, betting on volatility, started trading the fund more heavily. The halt caused the price of the fund to diverge from its net asset value, which would only correct after new shares were issued.

RAISES EYEBROWS

Volatility traders have been noticing big swings in TVIX all week. At the start of the week, the ETN, which aims to double the daily move in an index tracking short-term VIX futures, rallied about 7 percent when VIX futures were actually down about 3 percent due to what some traders called a short squeeze.

On average, on a daily basis, the TVIX moves about up and down in percentage terms as the VIX does and twice as quickly as front-month and second-month VIX futures.

The ETN gave back most of its premium to its indicative value on Thursday when it plunged in its heaviest day of trading since mid-February. It had been trading to a huge premium to its net asset value.

"The timing of the collapse of the Net Asset Value of the fund was certainly suspicious," said Chris McKhann, analyst at optionMonster.com.

McKhann noted the TVIX's price was 89 percent greater than the net asset value of the note on Wednesday, and that difference has since collapsed as investors scrambled to dump their holdings.

"Most of the people who owned the TVIX did not understand that it was trading at a huge premium to its NAV, let alone understanding the product itself. But this does not help to restore retail investors and traders faith in a fair market," McKhann said.

Volumes in the ETN surged in mid-February as investors increasingly turned to exchange-traded products as a way to bet on or hedge against volatility, especially in the prolonged complacency in the market.

"The price action in this ETN became purely speculative driven by no fundamental valuation whatsoever," said Scott Maidel, senior portfolio manager, equity derivatives at Russell Investments in Seattle.

Due to the carry cost associated with these types of volatility ETNs, they are typically used as trading instruments rather than buy-and-hold investments.

Carry costs occur when the VIX futures term structure is upward sloping - where the front month futures contract is priced at a lower cost than the back-month contract, which the ETN is buying. The price difference in these contracts has been rising, a greater cost for investors who thought they could buy and hold the note.

The rise in volume was a concern to Credit Suisse, which stopped issuing shares, citing "internal limits" for the size of the ETN. There were concerns that demand for the security would start to have an undue influence on the volatility futures market, rather than tracking those contracts.

The VIX - the CBOE Volatility Index - is the market's favored gauge of investor anxiety. It is not a traded index, but futures contracts trade on the CBOE, and a handful of exchange-traded products track those futures contracts.

(Reporting By Angela Moon in New York and Doris Frankel in Chicago; Editing by Andrew Hay and Diane Craft)

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