TVIX: an expensive lesson about an exotic exchange traded note

TVIX

TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

the SEC, Citigroup and moral hazard

This is an update and elaboration on my November 11th post about Judge Jed S. Rakoff, the SEC and Citigroup.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

short selling as an investment tool: risk arbitrage

what it is

Risk arbitrage is an investment strategy based on exploiting pricing anomalies in mergers and acquisitions.  It’s one of the older hedge fund-like activities in the financial markets.

Let’s say that company A, which is trading at $30 a share, announces a bid to acquire company B, which is trading at $50 a share.  The bid is for stock, at a proposed rate of two shares of company A stock for each share of company B.

after a bid is announced

The bid will have two consequences:

–company B is “in play.”  Chances are it won’t survive as an independent company.   B’s top management and board of directors will be focussed on obtaining a higher price than A has initially offered, and possibly on finding a more suitable (or la least, different) merger partner (see my post on black and white knights).

–the way professional investors evaluate B’s stock changes.  Right now, and for as long as acquisition is a possibility, B’s stock no longer exists as an independent thing.  In the simplest case, one where the merger is friendly, no other bidder is in sight, regulatory and shareholder approval appears assured and the date for merger is also reasonably certain, B’s stock is already A’s stock under a different name.

In this case, the arbitrage is straightforward.  Shares of A are trading at $30.  Shares of B, which are really A shares in disguise, are trading at $25.  Therefore, the arbitrageur buys B and sells A short until the two prices–adjusted for the cost of money until the merger is completed–converge.

Life isn’t always this simple.  Arguably, a skillful risk arbitrageur doesn’t want it to be, either, since in the plain vanilla case just described, the arbitrage opportunity is gone in a flash.  The arbitrageur’s analysis of a bid situation typically has three parts:

1.  What is the true value of company B to a trade buyer, or–arbitrageur’s nirvana–a private equity firm?

2.  What are the chances of achieving this value?  In particular, who would pay the full price?  …will that entity bid?  …what regulatory obstacles would he face?

3.  What happens if the bid on the table is withdrawn?

The calculation of the price B should be trading at is a straightforward expected value.  The arbitrageur’s decision to buy or not will be a return on invested funds keyed off it.

what the price of B is saying

Figuring that it would take six months after announcement for an agreed merger to take place, the cost of funds should only amount to one or two percent of the price paid for B shares.  In this case, B shares should initially trade, I think, somewhere around $57 (remember it’s a 2-for-1 deal) and gradually drift up toward the $60 offer price.

Sometimes, the price of B spikes above the offer price.  This usually indicates that arbitrageurs believe a better bid is in the offing, either from company A or from another party.

Sometimes, the price of B goes up, but only modestly.  This typically signals arbitrageurs’ beliefs that regulatory or other hurdles diminish the chances of the combination ever taking place.

Occasionally, the price of A will drop sharply, indicating the stock market doesn’t like the deal at all.  In an agreed merger, this will drag B’s stock down with it.  Often, there’s good reason for investor worry.  On the other hand, a bid announced in March of last year would doubtless have unleashed a torrent of selling in A’s stock.

before a bid–prospective arbitrage vs. value investing

Actual arbitrage is event-driven.  What do arbitrageurs do all day if all their capital is committed to deals?  Like other professional investors, they go to conferences or to the gym.  Maybe they blog, although that would be hard to get past the compliance department.

On the other hand, what if there are no deals?  Sometimes, arbitrage firms try to anticipate areas where merger and acquisition activity may be brewing and buy shares of likely acquisition targets.  When I started writing this section I was tempted to say that in doing so, these firms act just as ordinary value investors would.  While it’s true that growth investors end up holding acquirers and value investors their targets, I don’t think my thought is quite right.

It is possible, I think, to identify broad areas where, conceptually at least, industry consolidation is likely.  For example, when the EU began to drop customs controls at the borders between member countries, this unleashed a multi-year wave of mergers and acquisitions in the grocery industry.  Supermarkets wanted to rationalize their distribution networks and achieve larger scale to give them more bargaining power with their suppliers.  This, in turn, triggered a second wave of consolidation, this time among packaged goods companies, as they sought to reestablish their negotiating advantage over the supermarkets.

At present, the computer hardware and software industries strike me as ones where consolidation will continue.  Also, China seems to me to be very eager to turn its dollar holdings into physical assets by buying companies that either will provide that country with natural resources or that will be distribution outlets for its finished goods.  Washington, however, like Paris, seems bent on preventing this from happening in the US.

short selling as an investment tool (II): hedged vs. unhedged

Short selling is involved a number of hedging strategies.  Short sellers, however, like any investors, can run both unhedged and hedged positions and portfolios.

Unhedged

It’s important to distinguish between a hedged position and a diversified position.  Both are ways of reducing risk.  But they’re not the same.  Diversification is having three cows in case one stops giving milk.  Hedging is having one cow but taking out an insurance policy in case the animal drops dead.

You can have a diversified portfolio consisting solely of short positions, just as you can have one that is made up completely of long positions.  In both cases, you’re at least somewhat protected against the risk that one or two positions go wrong.  But in the former case, you’re still exposed to the possibility that the overall market rises sharply.  In the latter, you still have the risk of a sharp market decline.

Dyed-in-the-wool short sellers run unhedged short portfolios.  Operating this way means taking on a lot of risk, and requires a person who is temperamentally suited to the short side and has a considerable degree of skill. The reason is the more open-ended possibility of loss if the positions move the wrong way. But the structure is pretty straightforward.

You can have as an objective either to have the names you’re short to lose money in absolute terms, or simply to underperform an index like the S&P 500.

Hedged

It’s much more common for short positions to be components of a hedged portfolio, that is, one that includes long positions as well.  Three ways to do this:

1.  One of the oldest instances of hedged portfolios is risk arbitrage, a merger and acquisition strategy, where a manager typically buys the stock of the target and sells the acquirer short, after a deal is announced.  More about this in a post next week.

2.  Another is the original hedge fund, what would be called today a market-neutral strategy, where the manager holds equal dollar amounts of both long and short equity.  If you were to read the marketing literature for this kind of portfolio, the managers might say things that would lead you to believe that by doing so they have hedged away the risks associated with overall market movements.  Maybe so.  Personally, though, I think it’s very hard for a manager not to let a directional bias–his thoughts about where we are in the business cycle–seep into both long and short active positions.  In other words, if you think the market is going down, you’d be short cyclicals and long defensives, and vice versa.)At the very least, performance has two components:  (out)performance of the long positions against the index pus (under) performance of the shorts.

3.  What are called pair trades have become popular over the last decade or so, both with high net worth individual investors and with modern hedge funds (which, to my suddenly curmudgeonly eyes, have nothing more than a fee structure in common with the traditional ones described in the last paragraph).  Pair trades consist of two stock ideas, one long and one short, typically both in the same industry and probably covered by the same industry analyst–who is the one suggesting the trade (and hoping the management of the company on the short side doesn’t find out).

The concept is to reduce the active bet you’re making to one about the relative operating efficiency of two companies in the same or allied industries.  In theory, factors relating to the strength of the global economy or the health of the industry involved are taken out of the equation this way.  Like the market-neutral strategy, gains or losses are supposed to come from what’s different about the two members of the pair.

Examples from the recent past might be:

Long Toyota, short GM

Long HP, short Dell

Long McDonalds, short Starbucks

or even

Long Wal-Mart, short Target (weak economy)

Long Target, short Wal-Mart (strong economy)

In the first two cases, the contrast is between strong management and weak management (of course, Toyota turned out not to be so strong in the end).  In the last three, and very clearly in the last two, strength/weakness of the economy has snuck back in.

My thoughts

Pair trades—small positions only!—while riskier than simple long positions and requiring careful/continual monitoring, strike me as okay for individuals to try their hands at.  The rest of the short-related world–hedged or not–should be left to professionals.

short selling as an investing tool (I)

Yesterday I argued that there’s a long-term tendency for the stock market (in any country outside Japan) to rise.  There are two reasons:

–national monetary policies are set up to avoid deflation by encouraging mild inflation, so nominal prices generally rise; and

–at least some people aspire to economic gain, or to creating new products and services, so in the absence of government policies that discourage these activities, real GDP also tends to rise.

Where does this leave short selling?

As it turns out, my first portfolio job–after four years as an analyst–was (luckily for me) working for an extremely skilled investor on a short portfolio.  So I know a little about the subject.

I’m going to write about this topic in two posts.  Today’s will cover the basics.  Tomorrow’s will be about hedging techniques used to control the substantial risks that shortsellers take on.

why professionals find shorting attractive

Two factors make short selling theoretically attractive, even in a world where stock prices generally rise:

creative destruction:  Often, the rise of a new product or service sounds the death knell for an older competitor who is unwilling or unable to adjust.  Specialty retailers began to replace department stores in the move to the suburbs thirty-five years ago.  They are being supplanted now by on-line commerce, as well as by the reemergence of more flexible generalists like WMT and TGT.

less competition:  Most professional investors gravitate toward the long side and toward fast-growing new industries.  As a result, there may be four or five sharp minds looking at every long idea for every one looking at a short.

why it’s not for everyone

1.  I think shorting is harder than buying a stock you think will go up.  The long side has many types of specialized investors.  For instance, there are large cap and small cap specialists, value investors and growth investors, special situation investors.  For a stock to rise, one of these groups has to like it.

But for a short idea to go down, everyone has to dislike it.  Not only do you have to have a certain quirky turn of mind (a kind of Schadenfreude) to be a successful shortseller.  You also have to be able to put yourself in the place of groups with different parameters for what makes a good stock and think out why your potential short won’t interest any of them.

2.  It’s riskier to short stock than to be a buyer.  When you short a stock, you borrow shares from someone else and sell them.  You  hope you can buy them back later on at a lower price, so that you can return them to the original owner and close out your position.

In the meantime, you have to post collateral, which is held by a third party.  The amount of the collateral needed to support the short position goes up if the price of the stock you’ve shorted rises–sort of like margin debt in reverse.  Two implications:

–you can be absolutely correct, but being early, with an insight that runs counter to the mass mind of the market, can be a killer.  Suppose, for example, you thought MSFT’s best days were behind it at $35 a share in early 1999 and shorted it then.  You would have been right on a two-year view.  But in the intervening time the internet craze drove the stock up to close to $60.

It would have been an even more testing experience if you thought PMC Sierra (PMCS–now a $8- stock) was over valued at $50 in late 1999.  Again, you would have been right on a longer-term view.  But that stock, smaller and zippier than MSFT, flirted with $250 a share both in early and in late 2000.

Yes, PMCS and other internet-related chipmakers were unusual cases.  But the fact remains that in any short you run the risk of running out of collateral and having to cover your position at a substantial loss before the world realizes you’re right.

–a related risk, though more of a worry for professional shortsellers than for you and me.  Your broker can change his mind about your creditworthiness and increase the amount or type of collateral he requires.

That’s it for today.  Hedged vs. unhedged shorting tomorrow.