Black Peak Capital Urges Investigation into the Termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV)
Fairfield, Connecticut, February 23rd, 2018
As a provider of financial advice for the VIX futures market and related exchange traded products (ETPs) to hundreds of high net worth and mass affluent retail investors, Black Peak Capital urges US government regulatory agencies like the SEC & CFTC and financial self-regulatory agencies like FINRA to undertake a thorough investigation into the events on February 5th between 4:00pm and 4:15pm EST that led to the termination of the VelocityShares Daily Inverse VIX Short-Term ETN (XIV). Between the stock market close at 4pm and the VIX futures market close at 4:15pm when geared VIX ETPs usually rebalance their exposure to VIX futures, we observed a VIX futures seller strike (disappearance of VIX futures sellers). The seller strike resulted in surge pricing of VIX futures that had no fundamental driver in either S&P 500, S&P 500 futures or VIX (S&P 500 Volatility Index) movements due to any new market moving information. As a result of this 15 minute surge pricing in the VIX futures market, the Inverse VIX ETPs set their daily NAV to a level where investors lost -90% of the money they had in these products at the market close at 4pm that day. The Inverse VIX ETPs failed as investment products that day because they did not provide the short VIX futures exposure that they had promised investors. Investors who shorted February and March VIX future contracts directly at 4pm on February 5th and held those positions through February 6th saw gains. Investors in XIV and SVXY over the exact same time period suffered -90% losses. The products failed to provide the synthetic short 30-day VIX futures exposure they had promised in their prospectus. We think that an investigation is necessary to learn why the surge pricing occurred and whether changes to the VIX futures market structure can be made to ensure stability in the future.
VIX Futures Market and VIX ETPs Need Better Protections
As active investors in the VIX futures market and related ETPs and as advisors to a very engaged community of investors in this asset class, we want to see it expand and grow in the future. We believe volatility is an asset class that should be an integral part of all investor portfolios alongside stocks, bonds, real estate and commodities. Volatility products can provide yield during periods of low market volatility and protection during periods of high market volatility. We would like to see VIX products strengthened through stronger consumer protection regulations and through the introduction of more resilient exchange traded products. We would like to see proper guardrails put in place to ensure trust in the marketplace. Other marketplaces have trade halts and various other techniques to protect investors from surge pricing and we believe the VIX futures market could benefit from some of these best practices. We also think that Option Level 2 clearance should be required for investors who want to trade VIX futures based ETPs due to the toxic combination of inherent complexity and deceptive periods of outperformance.
VIX Formula Needs Improvement
The CBOE S&P 500 Volatility Index (VIX) uses a bid/ask mid-point pricing for options included in its formula. Mid-point pricing for far “out-of-the-money” (OTM) long dated options can be highly volatile on a day-to-day and intra-day basis without change in market conditions. Such an option position can often double quickly in value simply because a bid was withdrawn and then a much higher bid was entered. Likewise such an options position can quickly halve in value. We think that a mid-point valuation technique can be subject to manipulation in options where there is lack of adequate volume. But even if not manipulated, this valuation technique introduces a high degree of volatility that should not be welcome in an index that is as central to modern financial markets as the VIX. We urge the SEC, CFTC, FINRA and other government agencies to investigate the allegations of VIX index manipulation. We also urge the CBOE to modify the VIX formula and make it less susceptible to manipulation attempts by market participants. We strongly believe in the VIX as the premier measure of risk in the financial markets and we want to see it function properly and free of allegations of impropriety.
Short VIX Products Remain Dangerous
Nominal price bears no inference to value
We have a warning for investors who look at the exceptional returns of short VIX products like SVXY from 2016 and 2017 and estimate that similar returns will be available this year and are rushing to invest after the February 5th crash lured by low nominal prices. The nominal price of a VIX futures product bears no inference to its inherent value because it holds a mix of VIX futures contracts which expire every month. SVXY gains during periods of low or declining market volatility and loses during periods of high or rising market volatility. The price of SVXY can go up infinitely or it can go down infinitely depending on market conditions. SVXY can go from $100 to $10 to $1 to 10 cents and vice versa.
Volatility drag is at historical highs
SVXY is an Inverse ETF and the process of daily rebalancing of VIX futures holdings can make its NAV lose value during volatile periods for VIX futures. This is a phenomenon called “volatility drag”. Measures of volatility drag in February like the CBOE VIX Volatility Index (VVIX) are at the highest levels in recorded history which means that SVXY is more susceptible to volatility drag losses now than ever before.
Stocks and volatility can go up together
The stock market is at historically high valuations and periods of high valuations are often marked with heightened market volatility. The S&P 500 can have a very positive year in 2018 but if that return is achieved through a path of high volatility, the SVXY can lose money on the year. 2014 is an example of a year when the S&P 500 made more than 10% while the SVXY lost nearly -10%. Many investors think that short VIX products are strongly correlated to the stock market because there is academic research out there that states that short VIX products are similar to leveraged S&P 500 products. We think that this academic research is not correct because of insufficient data. Short VIX products have not existed long enough to be evaluated through all market environments and particularly through a rising interest rate and hyper inflationary market environments. It is possible for the stock market and for volatility to rise together in tandem for an extended period of time. That would lead to the market gaining and short VIX products losing at the same time. Investors who are considering investing in short VIX products as a proxy for leveraged stock market exposure should consult with registered investment advisors who are well versed in the risks of these products and can provide qualified advice.
About Black Peak Capital
Black Peak Capital, LLC is an investment advisor registered in Connecticut specializing in the VIX futures market and related exchange traded products. Black Peak Capital’s owner Stephen Aniston is a publisher of the weekly State of Volatility investment newsletter and the VIXCONTANGO.COM website which is a leading provider of investment analysis for the volatility asset class. Our clients are primarily high net worth and mass affluent retail investors who together have dedicated over $200 million to volatility strategies. More at www.vixcontango.com
VIX: The CBOE VIX (S&P 500 Volatility Index) is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX is forward looking and seeks to predict the variability of future market movements. This is in contrast to realized (or actual) volatility which measures the variability of historical (or known) prices.
Short VIX, Short Volatility or Inverse VIX: A “Short VIX”, “Inverse VIX” or “Short Volatility” investment is one that is designed to correlate negatively or move opposite of the Chicago Board Option Exchange Volatility Index (VIX). These investments may take many forms but are typically Exchange Traded Funds (ETF) or Exchange Trades Notes (ETN) that hold short exposure to VIX futures contracts.
Geared ETPs: These are Exchange Traded Funds (ETF) or Exchange Trades Notes (ETN) that provide a leveraged or inverse exposure to an asset class. They may be designed to have various ratios to the daily movement of an asset class (for example 2 times or .5 times) or the inverse of the daily movement (-1 times or -2 times). Geared ETPs are forced to rebalance their exposure to the underlying asset class every day.
SVXY: ProShares Short VIX Short-Term Futures ETF seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the S&P 500 VIX Short-Term Futures Index.
XIV: The VelocityShares Daily Inverse VIX Short Term ETN provides -1x leveraged exposure to an index comprising first- and second-month VIX future positions with a weighted average maturity of 1 month.
VVIX: The VVIX is a volatility measure that represents the expected volatility of the 30-day forward price of the Cboe Volatility Index (the VIX®). It is usually called a volatility of volatility measure. It is this expected volatility that drives the price of VIX nearby options. The VVIX is forward looking and seeks to predict the variability of future VIX movements. This is in contrast to realized (or actual) volatility which measures the variability of historical (or known) prices.
Black Peak Capital, LLC