A follow-up to volatility hedges

It’s kind of funny.  After today’s TVIX catastrophe which we covered in our last blog post, Credit Suisse decided to take some action.  In the original post I didn’t get into the details of why the fund crumbled.  In short, it crumbled because Credit Suisse stopped issuing new shares in what is known as “creation units.”  The fact that they stopped creating new units set the stage for today’s decline.  Since they weren’t issuing new units, everyone who wanted to get long volatility drove the price of TVIX up so high that it was trading at a 40% premium to its net asset value (think finite supply with increasing demand).  Today, arbitrage traders sold the **** out of the fund to arb the premium back towards NAV.  Credit Suisse, recognizing the problem (after investors had lost millions of dollars), issued the following press release this evening (provided in its entirety to prevent any editorial bias):

Credit Suisse Plans to Reopen Issuance of VelocityShares Daily 2x Long VIX Short-Term ETN (Ticker Symbol: “TVIX”) on a Limited Basis.

Credit Suisse has filed a registration statement (including a pricing supplement, prospectus supplement and prospectus) with the ETNs and Exchange Commission, or SEC, for the offering of the ETNs. Before you invest, you should read the applicable pricing supplement, the prospectus supplement dated March 25, 2009, and the prospectus dated March 25, 2009 (File No. 333-158199-10), to understand fully the terms of the notes and other considerations that are important in making a decision about investing in the ETNs. You may get these documents without cost by visiting EDGAR on the SEC website at www.sec.gov. Alternatively, Credit Suisse or VLS Securities LLC or any agent or dealer participating in an offering will arrange to send you the applicable terms sheet, relevant product supplement if applicable, prospectus supplement and prospectus if you so request by calling toll-free 1 800-221-1037. Alternatively, a prospectus for the products can be found at http://www.velocityshares.com/
Performance results do not reflect the deduction of fees, expenses, brokerage costs, or other risks or costs, the incurrence of which would have the effect of decreasing historical performance results. It is not possible to make a direct investment in the indices. The performance of the indices is not illustrative of the performance of any security, including ETNs, related to such index.
The ETNs are intended to be trading tools for sophisticated investors and should be purchased only by knowledgeable investors who understand the potential consequences of investing in a commodity index and of seeking inverse or leveraged investment results . This document is being furnished to institutional investors for information purposes only and may not be publicly disseminated. Past performance or results should not be taken as an indication or guarantee of future performance or results, and no representation or warranty, express or implied is made regarding future performance or results. This document does not constitute an offer to sell, or a solicitation of an offer to purchase, any security, future or other financial instrument or product. Investors should review the prospectus or offering document for any security, financial instrument or product and make their own investment decisions based on their specific investment objectives and financial position and after consulting independent tax, accounting, legal and financial advisors. The information contained herein (including historical prices or values) has been obtained from sources that VelocityShares LLC and VLS Securities LLC (together, “VelocityShares”) considers to be reliable; however, VelocityShares does not make any representation as to, or accepts any responsibility or liability for, the accuracy or completeness of the information contained herein.
For VelocityShares ETNs, VelocityShares and/or its affiliates receives compensation from the issuer of the ETNs and/or its affiliates in connection with a marketing program that includes promotion of VelocityShares ETNs. Additional information about the sources, amounts, and terms of compensation is described in the ETNs prospectus and related documents.
“VelocityShares” and the VelocityShares logo are registered trademarks of VelocityShares Index & Calculation Services, a division of VelocityShares, LLC.

Weeding through the legal jargon, it appears that they intend to start issuing new creation units to pull the ETN’s market value back into line with its NAV.  What a novel idea.  That’s why they earn their 1.65% management fee!

So, you think you know about volatility hedges?

Today I was reading an article about the bizarre trading pattern in TVIX — the double-levered long volatility exchange traded note (ETN).  That’s kind of a mouthful, but it basically boils down to a trade-able security that is meant to appreciate in the short-term as stock market volatility increases.  The oddity today was that 1) the stock market posted a 79 point loss, 2) the volatility index was up nearly 3%, and 3) TVIX fell by 29%!

The inexplicably backward move in TVIX occurred on nearly 30 million shares traded.  That’s roughly 3X the average daily volume.  This post, however, is not about explaining how you can lose money while holding volatility on a day that volatility goes up.  That conversation might be fodder for another post, or we can discuss it in the “Comments” section.

Rather, the bizarre activity led me to look at TVIX’s Pricing Supplement (Prospectus).  More specifically, I paged down to the “Risk Factors” section to see if it could provide any insight.  Three pages into the description of risks, I came across this gem:

“The ETN’s are only suitable for a very short investment horizon.  The relationship between the level of the VIX index and the underlying futures on the VIX Index will begin to break down as the length of an investor’s holding period increases, even within the course of a single Index Business Day.  The relationship between the level of the applicable underlying Index and the Closing Indicative Value and Intraday Indicative Value of the ETN’s will also begin to break down as the length of an investor’s holding period increases.  The ETN’s are not long term substitutes for long or short positions in the futures underlying the VIX Index.  Further, over a longer holding period the applicable underlying Index is more likely to experience a dramatic price movement that may result in the Intraday Indicative Value becoming equal to or less than twenty percent (20%) of the prior day’s Closing Indicative Value.  Upon such an event, your ETN’s would be subject to acceleration and you will likely lose all or a substantial portion of your investment.  The long term expected value of your ETNs is zero.  If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”

The emphasis on the last sentence was courtesy of Credit Suisse, not me.

So, let me get this straight…  if I hold the position for only a day, a bunch of things can happen that may make my holding go to zero.  If I hold the position longer term, it is likely that my investment will go to zero.

And I’d only have to pay 1.65% in expense ratio for the privilege!

Now I would certainly never make investment recommendations on this blog.  This is for informative/entertainment purposes only.  In that spirit, here is the link to the Prospectus if you think I’m joking.