Volatility Bets and ETNs: Be Careful What You Bet On

wsjlogoExtract courtesy of Spencer Jakab, Wall St. Journal. Full article available via clicking on WSJ logo on left side..

“..Now that volatility has emerged not only as a concept but an investment in its own right, there probably is no putting the genie back in the bottle. And while portfolio managers largely welcome the products, the droves of speculators drawn to VIX notes may be in for a wilder ride than they realize…”

The latest big worry to hit markets is an unusual one: calm. With stock prices high and various gauges of risk low, investors appear to have thrown caution to the wind.

That isn’t entirely true, though. Exchange-traded notes that profit handsomely from market-shaking events have boomed since the financial crisis. But they have two big shortcomings: They may not work as designed in another financial crisis since their value depends on the bank backing them. And due to the way the products work, anyone holding these for the long term will inevitably see their value erode.

Futures contracts linked to market volatility were pioneered by the Chicago Board Options Exchange CBOE +2.02% in 2004, offering a way for professional investors to hedge the risk of stock-market swings. The more accessible notes that opened bets on the CBOE’s Volatility Index, or VIX, only began after the 2008 crisis.

They have grown rapidly, with assets under management rising to nearly $3 billion. Their impact is wide-reaching; they form the lion’s share of turnover in a derivatives market capable of hedging $200 billion in stock portfolios, according to KKM Financial.

One popular product with the catchy name of the VelocityShares Daily 2x VIX Short-Term ETN is designed to produce double the daily return of short-term VIX futures. Had it been around in September 2008, it would have surged by over 1,000% during the next three months. Or it could have gone to zero. That is because the notes are dependent on the firm sponsoring them. The VIX is just a calculation based on the prices of options for the S&P 500 index. So unlike oil futures, contracts tracking the VIX aren’t backed by anything besides the promise of a bank to pay the return on the index.

Yet those who buy these notes are forgetting history. In a true meltdown, so-called counterparty risk can flare. After all, investors who owned ETNs backed by Lehman Brothers in 2008 had to get in line with the collapsed bank’s other senior unsecured creditors. An ETN also could suffer if investors simply grow fearful about a firm’s creditworthiness.