Volatility ETFs untested

When you think of volatility as an asset class, it has unusual features: it can never go to zero; it does not rise over time; and, at some point, it will surge to the upside in an inverse relationship with downward-trending stock markets. As such, the VXUP theoretically will rise when the VIX surges and decline when volatility abates. VXDN should trade as a mirror image to VXUP on a daily basis.

These ETFs manage VIX exposure via monthly distributions, in which one ETF will pay out a distribution to the detriment of the other. Distributions are scheduled to occur on the 15th of the each month. These monthly distributions will be paid out as cash for the first six months and thereafter in the form of “paired” shares (depending upon liquidity).

The challenge in holding these shares is the host of caveats that accompany the monthly distributions. During periods in which the VIX is below 30, VXUP accrues a 0.15% charge daily, as well as a 4.5% monthly charge – which, for simplicity, we will call “hedge insurance.” No hedge insurance accruals occur on days when the VIX is above 30. What this means is that during periods of low volatility, VXDN has an embedded return of 4.5% (15 basis points times 30 days) per month, which is a direct cost to VXUP.

On the 15th of each month, VXUP will be entitled to receive a distribution, minus the daily hedge insurance accrual, if the VIX has increased during the period. If the VIX declines during the period, VXDN is entitled to receive a distribution, plus the accrued daily hedge insurance.

Assume the following values after a reset occurs: VXUP and VXDN are US$25 per share and VIX is at 12. Over the next measuring period, VIX rises by 25% to close at 15. Thus, VXUP should be close at US$30.125, which represents the shares’ entitlement to a 20.5% distribution based on the 25% increase in the VIX minus the 4.5% hedge insurance cost. VXDN should be trading at approximately US$19.875, which represents the cost of the impending distribution.

At that point, a US$5.125 distribution will be paid to holders of VXUP, to the detriment of holders of VXDN. The shares will be reset again to reflect an equal weighting in the underlying VIX index. The opposite occurs should the VIX decline during the measuring period. If the VIX is stable during the measuring period, VXDN would earn the hedge insurance accrual at the expense of holders of VXUP.

The problem is that the VIX moves erratically and we should not expect periods in which there are not a host of exceptions; these exceptions are managed through a series of caveats in the prospectus. Both VXUP and VXDN are subject to a maximum 90% distribution during any period.

Further, if the VIX rises or falls by 75% at any point during a given period, there will be a “special distribution” paid from one ETF to the other. If a special distribution occurs, the ETF share values are reset automatically.

There also is a “corrective distribution” that comes into effect if, after 90 calendar days following your shares’ inception date, the shares’ value deviates by 10% or more from its net asset value over three consecutive trading days. Look for multiple corrective distributions because of the complex arbitrage relationship between VIX cash and VIX futures.

The corrective distribution will accompany any special distribution and regular distribution on the next regularly scheduled distribution date (or the special distribution date, if triggered).

If this complexity is not enough, you also could receive or pay out another distribution as a result of reverse share splits, which will occur during periods of extreme market volatility.

A volatility hedge that plays off the VIX cash index is new and, as noted, very complex.

This point is emphasized in a statement at the top of the prospectus: “Shares of the fund are intended for sophisticated, professional and institutional investors.”

These are not products that I would recommend for average investors. Even sophisticated investors should await proof that AccuShares can manage the numerous risks.

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