Credit Suisse's VelocityShares ETNs prompt debate over retail bid for volatility plays

By Emma Trincal

New York, Nov. 23 - Credit Suisse AG, Nassau Branch's planned series of six volatility-related exchange-traded notes to be listed on NYSE Arca next week are specifically designed for traders and not retail investors, according to VelocityShares LLC, the company that will be marketing the notes.

This commitment to the institutional market prompted some market sources to debate the role and place of volatility-linked notes in the portfolio of a retail investor.

The reasons behind Credit Suisse's choice to focus on the institutional area aren't apparent given that some competing volatility products target both the retail and institutional markets.

One possible reason is that volatility products are seen as unappealing by many wealth managers in charge of investing for their retail or high-net worth clients, according to two financial advisers, who explained why - at least for them - these investments remain unattractive.

On the other hand, a sellsider said that the reasons behind this aversion can be easily explained but are not necessarily justified. In fact, he said that retail investors would benefit from getting more knowledgeable about volatility products.

For traders

The suite of the six new VelocityShares ETNs targets the professional trader, according to Greg King, chief executive officer of VelocityShares, the company that acts as the placement agent for the notes.

The ETNs provide short, long or double-leveraged exposure to the S&P 500 VIX Short-Term Futures index or the S&P 500 VIX Mid-Term Futures index, which gives traders many tools to hedge a portfolio and bet on volatility as an asset class.

The daily rebalancing of the futures contracts is also designed for hedgers as it allows them to balance risks on a daily basis.

"The daily rebalancing is particularly useful for institutional traders," a former structurer at JPMorgan said. "You start clear everyday. Everyday you begin with an almost zero position. That's why traders like it."

This structurer said that the feature would be a particularly good fit for traders looking to hedge or find substitutes to variance swaps.

A variance swap is a derivative used to bet on the magnitude of a price movement.

"Variance swaps are over-the-counter instruments that have counterparty exposure. Those ETNs could be judiciously employed to hedge those types of swaps, which are also structured around a daily rebalancing," this source said.

Some advisers don't like it

Meanwhile, some financial advisers said that they see little use in investing in volatility-related notes in general and these new ETNs in particular.

Their resistance is not necessarily based on the fact that they perceive that such products are not created for them. It is mostly because they do not see the benefits of allocating to volatility.

"I don't understand the whole thing. I've never been attracted to these volatility products," said Frederick Wright, chief investment officer at Smith & Howard Wealth Management.

"If you want to manage equity risk, there are different, more established ways to do it.

"One could use an option. I would tend to reduce my equity exposure depending on the opportunities and based on the reasons that made me decide that I have to reduce market risk in the first place."

Carl Kunhardt, financial adviser at Quest Capital Management, paraphrasing Benjamin Graham, the value investing guru, said that volatility products were not investments but speculative instruments.

"If I remember, Graham said that an investment must rely on analysis, it must promise safety of principal and deliver adequate return. If not, it's not an investment. It's speculation. Well I don't view any of these products as investments. That's gambling," he said.

"They're not based on fundamental studies on the underlying.

"The underlying index is not even tracking volatility. It holds future contracts on volatility, which are derivative instruments.

"With volatility, you're not making a directional bet. You're betting on the magnitude of the VIX, not the direction.

"It's a game I choose not to play, which is why I'm not a trader. I've seen Wall Street come up with all these schemes, which they call innovation."

Wright said, "My clients hire me to manage their risk. Investment management is the management of risk. It's not the management of returns."

Challenging for retail

The former structurer at JPMorgan said that all these objections were valid points.

"The challenge that volatility products presents to retail investors is how to measure the exposure," he said. "It's more difficult to measure the true exposure to volatility compared to just owning a stock.

"Volatility typically is tricky because what you own doesn't go up and down in value like a stock. What you're really exposed to is whether the market becomes more volatile. You don't buy direction. You buy uncertainty.

"If you believe the market will be more uncertain, you're buying volatility because you're certain about future uncertainty.

"The idea is: I believe the market is going to be crazy, but I am not sure which way it's going to go. You're investing in a different dimension."

A second reason that might put off financial advisers when it comes to volatility products, he said, is hedging, the main reason they are being used in the first place.

"It's really designed for hedging purposes because volatility will go up when the market goes down. But that relationship is not a perfect one. Many investors would find it more efficient to hedge by buying puts or selling futures. That's a pure hedge," he said.

Despite those drawbacks, the structurer said that individual investors should pay more attention to those products.

"I think retail investors, especially high net worth with significant exposure to equity, should be looking at investing in these volatility products because their portfolio may be too big to actively trade. It's a successful way to provide a hedge, although not a perfect one."

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