One of the worst things that can happen to an exchange-traded note is that it takes on a life of its own, unhinging itself from the assets it was built to track.
That’s what befell Credit Suisse Group AG (CSGN)’s VelocityShares Daily 2x VIX Short-Term ETN (TVIX) in 2012, when investors became obsessed with using it to bet against stocks and bought so much that it broke away from its moorings in the futures market. Two years later, the once-disgraced darling of equity bears is making a comeback, with daily volume jumping fivefold to 9.4 million shares a day since 2013.
Credit Suisse’s misadventure with its note known as the TVIX spurred warnings about the risks of exchange-traded products, the $2.4 trillion market where investors use single securities to track baskets of stocks or make bets on everything from the price of gold to interest rates. While precautions have been taken to prevent a repeat, the renewed interest is a cause for concern to some analysts.
“When there’s momentum in a product like the TVIX, people start following a trend without being careful and they all feed on each other,” Mark Shepherd, president of Chicago-based Derivative Strategy Consultants, said in a phone interview. “Market participants almost always have too short memory.”
Drew Benson, a spokesman for Credit Suisse, declined to comment on TVIX trading. William Lloyd, managing director at VelocityShares LLC, also declined to comment. The Darien, Connecticut-based company licenses names and trademarks to Credit Suisse, which is the issuer of the notes.
Volatility securities such as the TVIX become more valuable when market swings increase, making them an attractive choice for traders looking to protect gains in equities. The TVIX is designed to generate twice the daily return of a gauge tracking futures on the Chicago Board Options Exchange Volatility Index. The VIX moves in the opposite direction of the Standard & Poor’s 500 Index about 80 percent of the time.
ETNs are unsecured bank debt backed by their issuer’s credit, unlike exchange-traded funds that hold assets. Their overseers create and redeem shares in the open market based on the level of demand from buyers and sellers. Normally, the process of adding and subtracting to the supply of available shares allows them to move in tandem with whatever they’re intended to track.
That broke down with the TVIX in 2012 as investors demanded more and more of it to hedge gains in the S&P 500 that had reached 100 percent. Outstanding shares in Credit Suisse’s note bumped up against a preset limit established when the product was created in 2010, and the bank stopped making more. In the aftermath, the note veered as much as 89 percent away from the index it was created to mimic.
With the same bull market still going strong and the advance in the S&P 500 now approaching 180 percent, the TVIX is back in fashion. Investors have poured more than $80 million into the security this year, making it one of the 20 most-traded U.S. exchange-traded funds and notes.
“It could be people who are not familiar with the product’s history and see that two times VIX performance and get excited,” Todd Salamone, senior vice president of research at Schaeffer’s Investment Research, said via phone from Cincinnati. “Regardless of the motivation for trading it, there’s a growing interest for these products driven by uncertainty about the direction of the market.”
The Financial Industry Regulatory Authority published an alert in July 2012 warning investors of risks involved in “complex” exchange-traded notes. In a release titled “Exchange-Traded Notes -- Avoid Unpleasant Surprises,” the brokerage watchdog organization said the securities can be illiquid and don’t always track their underlying index.
An irony of the TVIX is that even before it went off the rails, it was hard to make any money in it over the long term. The note plunged 51 percent in 2011, falling on 56 percent of days that year.
Like any leveraged security, holding the TVIX over periods longer than a few days is risky because losses can snowball -- something Credit Suisse tells investors in its prospectus. Short-term traders who anticipate its direction stand to reap rewards: 51 times in 2011 it rose or fell 10 percent or more.
“It’s a way to hedge yourself against an accident,” said Frederic Jamet, a money manager at State Street Global Advisors France in Paris, in a phone interview on March 10. “Many people feel they may have to protect themselves given that we haven’t had a big stress moment in markets for a while.”
The ETN is down 1.1 percent this year.
The resurgence of demand for the TVIX has led Credit Suisse to increase the size of the fund. Shares outstanding in the gauge have risen to a record 24.8 million, compared with 1.4 million at the start of 2013, data compiled by Bloomberg show.
A month after it stopped creating new shares in 2012, Credit Suisse, under pressure to restore order to the product, reversed its curb on new creations and started to resupply the market. The bank’s move, designed to aid short sellers by lowering the cost of borrowing the note, whipsawed holders of the TVIX as it plunged 59 percent over three days.
In the TVIX prospectus, Credit Suisse said new share issuance may depend on the market’s willingness to sell the bank a hedge for the security, such as swaps. Any limitation on new shares created may “materially and adversely” affect price and liquidity, according to the Zurich-based bank.
Credit Suisse can more easily hedge the TVIX shares it creates given the expansion in volatility securities compared with 2012, making another suspension less likely, said Bill Luby of Luby Asset Management LLC. The TVIX price has been 1.3 percent above its underlying assets on average this year, the least since 2011, data compiled by Bloomberg show.
“The rise of other VIX products means the TVIX plays a smaller role in the market than it did in 2012, so Credit Suisse may not be worried about getting trapped,” said Luby, who trades volatility as chief investment officer of Tiburon, California-based Luby Asset Management. “People are getting comfortable now with volatility as an asset class and the revival of the TVIX is probably a sign of that.”
ETN providers may also be helped by record trading in VIX futures, which are often used to hedge the risk of the products they create. Average daily trading in the contracts has risen about 30 percent this year to 200,000 contracts, data compiled by Bloomberg show.
The TVIX has an annual expense ratio of 1.65 percent, compared with 0.95 percent for the ProShares Ultra VIX Short-Term Futures ETF (UVXY), which also delivers double the VIX return.
“It is very expensive to carry on this product,” Francois Chaulet, who helps oversee $350 million at Montsegur Finance SAS in Paris. “You have to be right on timing if you buy this.”
To contact the reporters on this story: Cecile Vannucci in New York at firstname.lastname@example.org; Alexis Xydias in London at email@example.com; Nikolaj Gammeltoft in New York at firstname.lastname@example.org