After the market went crazy, investors started learning about volatility in a way they may not have known about before. First, remember that volatility is equivalent to risk. The more volatile a security is, the higher the risk that you will lose money in that security.
Thus, your overall investment approach — which money managers have no clue about — is to create a long-term diversified portfolio with many non-correlated investments, which will reduce the overall portfolio risk.
My stock advisory newsletter, The Liberty Portfolio, takes this approach and, to my knowledge, no other newsletter does.
The markets had been pretty quiet and just kept going up, so volatility had been low. That meant that a measurement of expected volatility, called the CBOE Volatility Index (or “VIX”) was low. The VIX is an index derived from the prices of options premiums in the S&P 500 Index. As the market becomes more volatile, the price of options increases. Thus, more volatility = higher options prices, and the VIX will rise. The higher the number of the VIX, the more volatility we see in the market.
Being Wall Street, someone invented a way to trade the VIX on both the long and short sides. The VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV) crashed in value by 90% at one point.
This product, like other volatility products, are not actually exchange-traded funds (ETFs) but exchange-traded notes (ETNs). ETNs are unsecured debt obligations, effectively a promise by the issuer to pay so when someone sells shares in the fund, they are guaranteed to get the money reflected in the price of the ETN at the time of the sale.
But the issuer doesn’t want to be exposed to having to pay out all that money, because they might lose their shirt. So they will often hedge their own product using derivatives.
Well, the issuer of the XIV fund is Credit Suisse Group AG (NYSE:CS), wanted to reduce its short exposure as the XIV cratered. It doesn’t want to be on the hook for the possibility of a complete 100% loss. So in the prospectus, CS said that if XIV fell more than 80% loss in a single day, CS has the right to just liquidate the whole darn thing. Which means the XIV shuts down and you collect the value of the XIV on that day with no chance to ever recover what you lost.
That’s what happened, and it could happen to other ETNs as well.
There are three other short volatility products that could face the same problem, so you do not want to own any of them.
3 ETFs to Watch
VelocityShares Daily Inverse VIX Medium Tern ETN (NASDAQ:ZIV) could be in trouble. Again, we’re looking at a short volatility product that could draft down significantly if the market goes crazy again. However, there is a major difference between the ZIV and XIV.
The former was a fund that shorted DAILY moves in the VIX. The ZIV deals with MEDIUM TERM moves in the VIX because it is a fund that handles futures contracts that are weeks out.
VelocityShares VIX Short Volatility Hedged ETN (NYSEARCA:XIVH) cratered almost 80% on Feb. 5, but the fund is still open. The reason lies in its name — it was naturally hedged, even though it doesn’t look like the hedge did very much good. Still, this is something to steer clear of.
ProShares Short VIX Short-Term Futures (NYSEARCA:SVXY) is still open, despite an almost 90% decline on February 5. It is a bit different from XIV in that its prospectus doesn’t actually say what happens on a day like that.
Still, you have no business trading these securities because they are not investments. They are bets in a gambling casino, literally. Stay away and don’t look back.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at [email protected].