Here's One ETF You Never Want to Buy
Recently we got an ugly glimpse of the destructive capabilities that one type of ETF can unleash upon its victims. This nightmare ETF has mostly ensnared and damaged individual investors like you and me.
Let me explain...
From time to time investors become increasingly enamored with volatility. This makes sense, as volatility is a fact of market life. In 2020 - 2022 we saw volatility assert itself with a vengeance.
Over the years literally dozens of new ETF products have been rushed to market to quench this insatiable demand.
What’s extremely troubling is that these products are frequently unregulated, allowing the fund managers to literally write the rules as they go while reaping millions in fees and shady profits along the way.
What’s even scarier is that, under current securities law, their actions fall well within legal boundaries.
If there is one ETF product sector that you should avoid like the plague, it’s Volatility-oriented exchange traded notes (ETNs).
These instruments are deeply flawed. They are too complex for their good (and for the good of most individual investors). And worst of all, to participate in them is to go up against fund managers who do not serve your best interest.
Essentially, you’re directly getting involved and going up against their proprietary trading book as they masquerade as market makers.
All it takes is a little research and due diligence on how these products actually work, and you’ll soon discover that they are being grossly misinterpreted to millions of investors.
Their make-up is a stark contrast to other popular ETFs like SPDR Gold Shares (GLD) and iShares Silver (SLV). With those, the funds' assets are backed by physical gold and silver bars.
Equity ETFs, such as SPDR S&P 500 (SPY) and iShares Russell 2000 (IWM), are backed by and constantly rebalanced by the underlying stocks in the precise proportions required to mimic the indices they were designed to track.
But Volatility ETNs are an entirely different animal and must be actively managed. There are subtle differences between the menu of products, but inherently they all exhibit similar characteristics, and present the same flaws and dangerous risks to individual investors.
The Phantom Menace
The big difference is Volatility in itself.
Let’s get one thing straight: Volatility is not an asset class! It’s a mathematically-derived indicator that measures implied movements in the price of an asset.
And most of the Volatility ETN products model some sort of variation of the widely followed VIX index that measures implied volatility on the S&P 500 index.
The VIX itself is not a tradable index, and serves merely as a “spot reference.” But what are tradable are VIX futures and options on VIX futures.
(By the way, the "Contango Effect" -- lower prices in nearer dated contracts versus higher prices in further dated contracts -- is a major flaw that undermines the valuations in volatility ETNs.)
This is the secret control room behind the curtain and it exposes all the problems with these products.
You see, as investors pile in or out of these ETNs, the fund managers are not swapping out tangible assets, stocks, or commodities to balance their book. Instead, they’re swapping out futures and options that settle in cash, which is unlimited, like a bottomless pit. In other words, nothing real is collateralized.
In fact, if you dive into the prospectus on many of these Volatility ETNs, you’ll probably discover some pretty serious disclosures that should make any sane investor run for the hills.
For instance, Volatility ETNs are backed by senior unsecured debt. What this means is that since there are no collateralized assets backed by the shares created -- like gold, silver or stocks -- your investment is backed by the full faith and credit health of the investment fund.
This is the compelling reason that volatility funds really only care about three things: Drawing investor flow to their products, charging fees, and creating trading profits from active management.
And it’s an even more compelling reason for you to avoid them.
Tyrannosaurus VIX Shows His Teeth
Here's a historical instance that can serve as a warning.
Way back on October 25, 2012 (Remember, this is a Costas Classic Column -- Editor)... we got an unfortunate taste of how dangerous these products can truly be. Many unsuspecting investors got caught holding the bag and were stuck with sizable losses.
The Velocity Shares daily 2x VIX Short-Term ETN (TVIX) is a double-levered volatility product run by Credit Suisse. The investment seeks to replicate twice the daily performance of the S&P 500 VIX short term futures.
Basically, the product is trying to give investors twice the bang for their buck on the VIX index. But, based on then-recent events, it appears that they might have been more keen on trying to fleece investors twice as fast.
Let me explain...
Below is a two month daily chart on the TVIX from back in 2012. It’s overlaid with the VIX, the index that it’s trying to replicate with double leverage.
(Click any image to enlarge)
The first sign of trouble occurred back on February 21, identified by the red arrow on the chart.
Notice the heavy volume leading up to that date. That activity is heavy accumulation of the ETN, where Credit Suisse was responsible for delivering the excess supply. To cover his short exposure, the fund manager buys assets, which in this case are VIX futures.
After being forced to take on such a huge futures position and cover the TVIX shares sold to investors, the position got very big. (Remember, ETNs are backed by the institution, and essentially the risk managers over at Credit Suisse were getting uncomfortable.)
So what did they do? They simply stopped issuing more shares and stepped out of the way and let investors make the market.
This basically turned the product into a closed-end fund, which artificially created a huge premium from the overwhelming demand.
After the volume calmed down and March VIX futures contracts settled (which reduced their position size and risk exposure), Credit Suisse suddenly announced they were getting back in the game.
While the public announcement came after the close, the “smart money” got the early look and front ran the news that Credit Suisse was about to dilute the issue back to normal NAV (the green arrow in the image above).
In essence, they popped the premium balloon and let all the air out, sticking it to individual investors to the tune of nearly a 60% loss in two days, while at the same time some “pretty smart” investors were selling ahead of the news and making out like bandits.
The blue arrow simply shows the divergence (correlation breakdown) between the TVIX and the VIX over the past week. That divergence is another unfortunate example of the dark side of Wall Street and how the system really works with such cruel intentions.
The takeaway here is that unless you are a very short term active trader, it’s best to avoid volatility ETNs.
But should you feel compelled to play these products... wait. Be patient and take bearish positions when volatility spikes. Use their flaws to your advantage.
It doesn’t happen very often, but buying some well placed Put options in the VXX can be a high probability juicy trade when the VIX spikes.
Thanks as always for reading,