May

20

I was excited to hear on Bloomberg radio about the launch today of a new VIX product — that allows investors to own/short the VIX without the negative carry of the futures and VXX. Sadly, upon reading the prospectus, I am very disappointed to see that this isn't actually how the product works. Savvy arbitrageurs, however, may see opportunities.

The VXUP is supposed to track the VIX positively, and the VXDN is supposed to track the VIX negatively. They are paired — so the profits from the VXUP offset gains/losses from the VXDN. Specs with a long memory may recall a similar structure in a crude oil ETF several years ago. However, that ETF blew up when crude went from 40 to 100+ — which wiped out the short crude ETF and so the long crude ETF stopped rising. The crude ETF pair was unceremoniously liquidated.

The creators of VXUP/VXDN think that they solved the 200% price rise crude oil problem — by having reset/distribution dates — where money flows between and out. And they imposed a 90% price rise cap in place — just in case the VIX quickly pops from 13 to 26+ . That indeed "fixes" the liquidity problem however it creates a much bigger problem. The VXUP/VXDN will not perform in line with the VIX if the stock market crashes — because the VIX will quickly go from 13 to 70ish.

But there's more.

The far more serious problem is that they embedded a "penalty" charge for the VXUP. (See page 3 of the prospectus). Here's the text: "During any Measuring Period and in order to create a balanced market for the Up Shares and Down Shares of the Fund, the Class Value per Share of each Up Share of the Fund will be reduced and the Class Value per share of each Down Share of the Fund will be increased by [a] fixed amount ["Daily Amount"]. In each Measuring Period where the VIX Index has a level of 30 or lower on the prior Distribution Date, the Daily Amount will be 0.15% per day of the Class Value per Share on the prior Distribution Date. If the level of the VIX is greater than 30, the Daily Amount will be zero."

WHAT THIS MEANS IS THAT THEY WILL BE CHARGING VIX LONGS AN ANNUALIZED PENALTY OF ABOUT 38% PER YEAR AND THEY WILL BE PAYING VIX SHORTS AN ANNUALIZED BONUS OF ABOUT 38% PER YEAR WHEN THE VIX IS UNDER 30. REGARDLESS OF THE VIX FUTURES TERM STRUCTURE. BUT IT APPEARS THAT THEY WON'T BE DOING THE REVERSE EVEN IF THE VIX MARKET GOES INTO BACKWARDATION.

I stopped reading the prospectus after this paragraph because it completely destroys my interest in the product — it has all of the VXX problems of roll-negative carry when the VIX is under 30, but it doesn't have the VXX positive carry when the VIX futures get backwardated. In essence, they have created a product that won't perform if the market crashes, but has all of the problems of the VIX futures and VXX (for volatility bulls).

So what's the arbitrage for Specs who like these things? I see an obvious one. They've arbitrarily picked and locked in a roll cost. And a cap when they think the market will backwardate. They will surely be wrong on both of those arbitrary decisions. For example: Right now the May15/Jun15 Vix future contango spread is 13%. So the 38% annualized penalty for the VXUP is vastly less than the negative carry for the futures roll. The May15/Dec15 futures roll is about 38%. So again, the VXUP penalty charge is less than the market roll. Hence, the obvious arbitrage is that the VXUP/VXDN has priced in a contango of 38% annualized — but the futures market has a different contango. They have also implicitly priced in the VIX level when the VXX goes from negative carry to positive carry (30%). The reality is that the VIX futures market will backwardate at VIX levels much lower than 30.

The way to exploit this arbitrage is left as an exercise for the readers.


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