Inverse Vix funds: shark chum

By FT.com | February 20, 2018

The value of SVXY, an exchange-traded fund whose price is inversely linked to volatility, crashed 96 per cent earlier this month. In an exchange with the Financial Times last week, sponsor ProShares said it had seen no "credible analysis" of the "material, harmful effect" such products might have on markets. Lex is happy to oblige.

The sponsors of "inverse funds" such as SVXY sell short futures on the Vix, the famous equities volatility index, in order to generate the gains they promise to investors. When they adjust their positions after a market move, they follow the momentum. A calmer market leads to gains which must be protected by selling more futures. Higher volatility triggers a loss in market value. Then shorts must be reduced. Traders are well aware of the destabilising potential of such feedback loops.

ETFs and allied products can only hurt markets if they are large. Inverse Vix funds were big by several measures. The market worth of SVXY and Credit Suisse's XIV alone near tripled to $3.1bn before they came unstuck. The Vix futures index they link to closed at 15 when market trouble was brewing. Investors would have gained $200m had that index fallen to 14 the next trading day.

This corresponds to a short position of 200,000 Vix futures contracts — 10 times the size of what would make a bank-risk minder choke. Here, the risk was shared among ETF investors, though the fund’s rules required unilateral action. The sponsors had to buy back almost all of the contracts when the index doubled in a day. That was equivalent to three-quarters of the average daily trading activity during the preceding month.

Every Vix trader could anticipate the trades the fund’s rules required the sponsor to make. Momentum trading gone wrong is usually illustrated by portfolio insurance’s role in the 1987 crash. Inverse Vix ETFs had a similar impact this month, as investors lost $2.4bn in moves detached from fundamentals. Credit Suisse vowed to close XIV. While strategies such as SVXY may serve a purpose for professional traders, these instruments will always pose some danger to the stability of markets.

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