As the title suggests, readers may not be overly familiar with the term Inverse Volatility ETF. However, in early February this year the term entered the mainstream with a bang! The market correction in the first few days of February led to the demise of one of the largest of such products the VelocityShares Daily Inverse VIX Short-Term exchange-traded note (VIX) with losses of up to 93%% for investors. Some say the product itself may have caused or exacerbated the market moves thus sealing its own fate. In this article I will try to explain what an Inverse ETF is and what happened, in as much as we can say with any degree of certainty.
So, what is an Inverse Volatility ETF (Exchange Traded Fund)? It is a product which tracks, usually passively, a particular underlying investment, index or strategy. Bear in mind that some ETFs employ active strategies but again, in general, these products passively follow some underlying investment, albeit that some periodic rebalancing may occur within the product.
In the case of an Inverse Volatility ETF the product is designed to profit if market volatility falls. Essentially, what folks were betting on by investing in these types of products was that the benign market conditions would persist. In fact, they were betting that the market would become even less volatile over time. Let’s break this down and try to rationalise what was going on here. First off, what is volatility? Volatility is the rate of change of the rate of change… huh?! Think about it this way, speed is the rate of change but acceleration is the rate of change of the rate of change. Mathematically this is what is known as a second order derivative. So, volatility refers to the rate at which or extent to which prices change. Again, investors in these products were betting that an already low level of volatility would get even lower. Of course this strategy worked very well for quite some time as equity markets went up gradually and central banks continued to support asset prices through their loose monetary policy and asset purchase programmes, amongst other factors which meant markets were pretty calm.
I like to compare this trade to betting on the weather in Ireland. Ireland, as we know, has a pretty wet climate, so imagine if it there was no rain at all for 30 days in a row (I doubt this has ever happened!). The most logical bet one would take, if betting on the weather were a thing, is to bet that on the 31st day it would pour rain! Holders of these Inverse ETFs were betting on yet another dry day. This isn’t just a flippant analogy though. Equities are a volatile asset class by nature (as Ireland is wet). Therefore, betting against this natural characteristic can only end in tears. Bear in mind, that some of these ETFs were in fact leveraged (funded by borrowed money)! That is, one could invest in a 2X version, for example, which gave you twice the daily move in the level of volatility!
This all ended on the 5th of February where, in a very brief period, the Dow Jones Industrial Average (the Dow) in particular (and US equities in general) took a sharp nosedive. Needless to say, volatility spiked in a dramatic way at this point and within minutes many of these strategies incurred losses in excess of 80%. For some products this subsequently triggered their closure. The VIX index which actually measures volatility on US equities stood at 17 on 2 February (a Friday). By the end of the day on the 5th it stood at more than 37. This doubling of volatility basically wiped out most of these Inverse ETFs. But wait; shouldn’t a doubling of volatility have equalled a halving of the value of such products and not the 80 and 90% losses we witnessed?? Well this is where it gets really tricky! In fact, some investors have been crying foul in relation to just this point and claiming the prices of the products did not behave in the manner that they expected (more on this point later!).
Firstly, I defy anyone to perfectly explain the price movements of any asset at any particular time – this sounds like an excuse! I am frequently amused by news stories which state “equities fall because of X”… as though this was definitive and the only reason. Equally, the very dramatic price falls in these inverse ETFs are unlikely to be fully explained by one or two factors. But here’s a few reasons why I believe the price falls were as dramatic as they were:
- Volatility begets volatility. In a cruel irony volatility tends to feed on itself and become more pronounced as investors’ fear levels elevate in a classic nasty feedback loop;
- Relatedly, intraday volatility will often be a lot higher than simple end-of-day observations will suggest;
- Selling begets selling. As we know, in an attempt to cut losses investors will often simply just sell out of positions. However, if everyone wants out at the same time then the market becomes disjointed and those making the market in these product (providing liquidity) will adjust prices downward in anticipation of further falls…. Which usually results in further falls by the way.
- Value does not always equal price. Without going into the ins and outs of the pricing of ETFs in general nor the pricing of these products specifically, often the value of a product will not equal the price of a product. Again, one might think of this in an Irish context in relation to property. We can all think of times where value did not equal price – in both directions.
- The VIX itself is not an investable index and is therefore difficult to track accurately.
The continual creation of new investment products by the financial services industry has given investors the greatest investment choice in history. That said, the complexity and the risk associated with some of these instruments can lead to catastrophic losses for investors, as happened to the investors in some of the reverse Inverse Volatility ETFs, this month. The old phrase Caveat Emptor “Let the buyer beware” is as relevant as ever in the current financial services industry.
Author: Peter Murphy, Managing Director, P. M. Murphy Ltd. Regulated by the Central Bank of Ireland. http://www.pmmurphy.com/
Disclaimer: The content of this article should not be construed as financial advice. You should consult a financial adviser to obtain advice appropriate to your individual circumstances.