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.
Two sessions of significant declines last week punctuated a
month of anomalous price moves in TVIX.
Pricing issues began when Credit Suisse AG, the bank that issues
TVIX shares, suspended new share creation after a rush of demand,
prompting the price to wander far from the basket of assets it was
meant to track. Prior to the temporary suspension the market price
tracked closely the index it was designed to track.
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, according to global
research and advisory firm XTF.
Credit Suisse spokeswoman Katherine Herring declined to
comment.
The halt triggered a supply-demand imbalance.
"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 averaged a daily move of
6.7%.
"TVIX was a way to hedge if the market took a big drop, and
offset my losses in other securities," Brehm said.
Many investors were unaware that external forces were
influencing prices, leaving positions exposed to declines brought
on by an influx in new creations. A day after the temporary halt,
Brehm bought 2,200 TVIX shares for $17.30 each.
The market price for TVIX rose to nearly double its intrinsic
value. On March 21, shares of the ETN closed at $14.43, 89% higher
than its $7.62 net asset value, according FactSet Research.
A day later, TVIX dropped 29%, amid a flurry of 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.
It is clear 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 shares had jumped to 4.1
million.
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.
"Once there's nothing restraining the supply of the product,
it's no longer scarce, so of course the price plummets," said Scott
Freeze, president of Street One Financial.
On Wednesday, TVIX rose 15% to $8.02.
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.
"Credit Suisse didn't violate the law here," Bill Singer,
partner at the law firm Herskovits PLLC. "The [net asset value]
disengaged from the reality, and Credit Suisse essentially turned
it into a closed-end fund," he said
The TVIX prospectus states "the market price of your ETNs may be
influenced by many unpredictable factors," including "supply and
demand."
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