UBS prices first European Volatility ETNs, but it’s for traders, sophisticated investors only

By Emma Trincal

New York, May 4 – UBS introduced two exchange-traded notes giving U.S. investors a first-time access to European volatility. One product is long, the other short. Either way, when it comes to volatility bets, experts warn investors to be cautious. In fact the prospectus states that the notes are only designed for sophisticated investors and not for retail buyers or buy-and-hold investors.

The two ETNs are both linked to the investable index referencing short-term futures contracts on the VStoxx, the European volatility benchmark, similar to the VIX in the United States.

UBS AG, London Branch sold $25 million of 0% VelocityShares 1X Long VStoxx Futures exchange-traded notes due May 3, 2047 linked to the VStoxx Short-Term Futures Investable index, according to a 424B2 filing with the Securities and Exchange Commission.

In addition, UBS also sold $25 million of 0% VelocityShares 1X Daily Inverse VStoxx Futures ETNs with an identical maturity date and linked to the same underlying index.

The two new ETNs are the first exchange-traded products allowing U.S. investors to get exposure to European volatility, according to a press release issued by Janus Capital Group Inc, which owns the VelocityShares brand.

There are no exchange-traded funds and options on the VStoxx at this time in the U.S. market.

The VStoxx is the benchmark for the 30-day implied volatility in large cap European stocks and is calculated based on the prices of certain put and call options on the Euro Stoxx 50 index.

Strong demand

Just as bets on U.S. volatility have become more popular via indexes based on VIX futures, demand from U.S. investors for a similar type of trading tool based on the European equity market has caught the attention of product designers.

Demand and market size for this growing asset class is promising:

Over forty VIX ETPs were trading at the end of the first quarter with an asset under management of over $3.7 billion, generating an average daily trading volume of $2.6 billion, according a report released last week by the options research team of Goldman Sachs obtained by Prospect News.

Investors have been showing interest in European volatility, said Nick Cherney, senior vice-president, head of exchange products for Janus Capital Group.

“Trading volatility on Stoxx has been steadily increasing over the last year as a function of an increased dislocation between the U.S. and the European economy,” Cherney told Prospect News in an interview.

“With Brexit, Trump, the French elections, there’s been heightened political risk.

“For a long time, people have traded the VIX as a proxy for global volatility. Now we’re seeing investors’ demand for market-specific vol.”

Cherney said that the VStoxx pair of ETNs is just a start.

“We haven’t launched a leveraged version yet but we would consider it in the future,” he said.

Longs take a beating

Investing or trading volatility is not for the faint of heart, sources said.

Long volatility performance as measured by the S&P 500 VIX short-term futures index has produced an annualized loss of 46.1% since 2005, noted the authors of the Goldman Sachs report.

They attributed the poor performance partly to the “large differential” between the volatility benchmarks and the futures contracts that track them.

The roll of the underlying futures contracts on the VStoxx Short-Term Futures Investable index may result in costs depending on the prices of the contracts at different expiration dates on the futures curve.

The VStoxx short-term futures investable index continuously rolls on a daily basis from the first month VStoxx futures contract to the second month contract, said the prospectus.

When the futures price is higher than the spot price, the index buys the next contract at a higher price than the proceeds received from selling the expiring contract. This phenomenon called contango is what drives the bad performance over time of long volatility strategies, according to the report.

“When the VIX is at historically low levels there is a natural tendency to want to get long volatility and VIX ETPs have become an increasingly popular trading tool. But buyer beware,” wrote Krag Gregory and Mathieu Droumaguet, the authors of the report.

Investors long volatility can generate high returns during a shock, when volatility spikes. Overtime however the rolling cost, or “negative roll,” will erode their return.

The prospectus cautions against the risk associated with contango. It suggests that only sophisticated investors buying over a short-term horizon should consider those products.

Naysayer

It was “sound advice” said a market participant.

“It’s really not something for retail investors because retail investors do not understand the concept of contango.”

Volatility was particularly risky since 70% of the time, VIX futures are in contango, he added.

“If you invest in such ETNs you’ll have these enormous roll costs,” he noted.

“You really have to time your entry and it’s very difficult if not impossible to do...including for sophisticated investors.”

The ETNs remain risky even as a short-term trading tool, he added.

Investors may have a lower negative carry on a daily basis but they will still incur decay, which will decrease the value of their contract albeit on a slower pace, he explained.

“In my 20 years career, I’ve never seen an instrument that gives you an opportunity to capture the perfect entry when you trade volatility either on the long or on the short side,” he said.

“Some expect to make money being short volatility. But you can get whipsawed all of a sudden and lose a huge amount of your initial investment.”

The other side

For Cherney, the most important thing for investors is to understand the strategy they implement.

Contango was unavoidable. It always has an impact on several different futures markets at any point in time.

“That’s the nature of trading volatility,” he said.

“Oil is in contango, S&P puts have significant decay, volatility is in contango.”

Contango was the equivalent of the negative carry investors incur when they buy put options on the S&P 500 index long term, he said.

“It’s just not true that you always lose money. You have to understand your strategy, regardless of whether you are long or short,” he said.

The products are simply not designed to be held long term, he explained.

“You can see very large spikes on spot volatility for VStoxx and in the meantime you have decay from futures and that’s usually negative. On the other side, you usually have highly positive returns from being short volatility, but you can lose a lot in a vol spike.”

Many investors aware of the recurrent negative roll yield take advantage of it.

“You can decide to be short,” he said.

“Plenty of people are trading both.

And “plenty” must have “done well” according to the Goldman Sachs research report, which reports that the S&P 500 VIX Short-Term Futures Daily Inverse index which tracks the return of being short a one-month VIX future was up 4,364% from March 9, 2009 through the end of this year’s first quarter.

Traders reign

The high turnover of VIX futures indicates that the securities move fast, a sign that it remains mostly a traders’ market.

The turnover of VIX futures is one of the highest in any of the most actively traded U.S. securities, including some very large-cap stocks.

Credit Suisse AG - VelocityShares Daily Inverse VIX Short Term ETN for instance turns over $1 billion a day, observed a source.

“With a market cap of $700 million, that’s less than one-day holding period in average,” he said.

On Wednesday, this ETN traded $956 million, which would have made it the 19th most traded stock in the U.S. ahead of Wells Fargo and Exxon Mobile Corp., he noted.

The two ETNs priced on May 2.

The issuer plans to sell additional securities from time to time at market prices.

The Cusip for the VelocityShares 1X Long VStoxx Futures is 90274E828.

The securities trade on Bats under the symbol “EVIX.”

The Cusip for the VelocityShares 1X Daily Inverse VStoxx Futures is 90274E810.

It trades on Bats under the symbol “EXIV.”

© 2015 Prospect News.
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