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The Fear Bubble

A mad rush of assets into short-term fear-index products distorts the VIX market.

Paul Justice, 04/04/2012

Be careful which asset classes you open up to the masses. They just might buy them.

That is advice for those ambitious exchange- traded product providers venturing into esoteric corners of the market. It is also a warning that the folks at boutique firm VelocityShares likely didn’t think they would have to consider. In late February, the fund provider’s backing bank, Credit Suisse, stopped issuing new shares of VelocityShares Daily 2X VIX Short-Term ETN TVIX, which provides leveraged exposure to the Chicago Board Options Exchange Volatility Index (VIX), otherwise known as the “fear index.” Demand was perplexingly too strong.

Many would argue that collecting too many dollars is a great problem for an asset manager to have, so the sudden closure raised questions. Why did investors run en masse to own short-term VIX futures tracking products in the first two months of 2012? And was the interest in these products really so strong as to justify shutting down the twice-leveraged note? Once the ETN essentially became a closed-end note, why did investors still demand it enough to push its price to a 15% premium over its net asset value? And, finally, why at times is there more money in short-term VIX tracking funds than there is in the actual VIX futures market?

You Never Know What Some People Will Buy
The answers to these questions may never be known, but it’s not that advisors and investors are a gullible bunch that will buy anything. They’re quite a particular group. Perhaps the digital age has simply empowered them to a point of overconfidence.

Advisors today have more analytical tools and data at their disposal than most institutions had 15 years ago. Armed with this power, advisors theoretically can execute complex yet academically sound strategies. Our research suggests that the results they’re getting are mixed. Advisors are skilled at selecting good funds, but problems still abound in getting the mix right.

Also theoretically, volatility as an asset class is an excellent diversifier for a balanced stock/bond portfolio. Its highly negative correlation to equity and credit markets provides impeccably timed zigs for market zags, and the size of its moves are often adequate to ensure that even a small position in volatility matters when it counts.

So much for theory.

In reality, properly performing a volatility asset-class investment strategy has proved to be mission impossible. In this article, we will investigate the prospects for volatility investments, address why investor demand can be rational despite some atrocious historical performance, and ultimately ponder whether or not the market can handle the demand.

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