VIX futures distortion meme as conceptual ecophagy

Thu, Aug 16, 2012 | Jared Woodard

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Here, some more evidence that the “VIX ETPs are distorting the market” theme has, in spite of the arguments against it, gone mainstream:

Hougan also cautioned investors from making use of volatility related products, singling out the $1.67 billion iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX).

“VXX has been and will be and almost forever will be an incinerator for investors’ money,” Hougan said, noting the ETN is down 80 or 90 percent over the past few years.

He noted that VXX “has completely distorted the market for volatility futures, in part because of the contango problem associated with futures-based investments.

Now, in fairness to the original proponents of this view, he simply misstates the argument. If volatility ETP volume is (somehow) “distorting” the VIX futures market, it has nothing to do with contango. Contango is a problem like laws of physics are a problem. Contango happens everywhere: there is the time value of money, to start, and also the higher cost of longer-dated instruments due to basic uncertainty. In futures markets for physical commodities, there are storage costs. And so on.

The last sentence in that quote isn’t actually up for dispute, because it doesn’t make any sense. He says that because futures-based investments have a “contango problem,” and since VXX invests in VIX futures, it has “completely distorted” the VIX futures market. But if futures markets have a “contango problem,” then they are already distorted by definition – there’s no logical room for VXX uniquely to make anything better or worse.

The original distortion argument, if you want to call it that, was that surging volatility ETP volume meant that issuers of ETNs like TVIX couldn’t cover their issuance without moving the underlying markets. Since moving the underlying markets would eat away at their profits from issuing new shares, the issuers chose to stop rather than issue shares, distort markets, and get no profit for their trouble. There was some evidence in February 2012 that Credit Suisse stopped issuing TVIX because they couldn’t get their orders done in VIX futures or variance swaps without giving up all their edge. The argument was always about the economics of issuers’ ETN business, i.e. “should we keep issuing shares, if hedging our issuance means we don’t make a profit?” It was never about some Zero Hedge-y apocalyptic broken market.

And as we’ve argued several times before, there just wasn’t any evidence that VIX futures were ever actually distorted. VIX futures prices were in line with historical relationships to variance swap rates and SPX option implied volatility across the curve. To claim, in spite of this evidence for normalcy, that volatility ETPs somehow distorted the market requires you to claim that the comparatively small TVIX vega notional was, at its height, driving the prices of SPX options. Which is a reductio if we’ve ever seen one. While it’s not, strictly speaking, impossible for volatility ETP issuance to distort the futures market, notice that such a situation would require an ETN issuer to choose to actively lose money. Perhaps the officers at Credit Suisse responsible for charitable donations have elected to make their gifts in a particularly opaque way?

What’s interesting, too, is that while this baseless conventional wisdom used to be restricted to leveraged products like TVIX, now it is apparently a meme applicable to VXX as well. The distortion meme is like a conceptual grey goo, swallowing up every exchange-traded product that cannot be understood without first reading the prospectus. The above comments were made in an “avoid these ETFs” segment for CNBC, natch.

In a surprise twist, we totally agree with the conclusion. Retail investors should probably avoid VXX if they aren’t going to trade it in a tactical, market-aware dynamic fashion. But the fact that Hougan reached the right conclusion for the wrong reasons doesn’t mean television segment producers wouldn’t be well-advised to book more guests who have some first-hand experience in options markets.

Source:
Hougan On CNBC: Avoid These Five ETFs,” Index Universe, August 15, 2012


14 Comments For This Post

  1. Steven Place Says:

    I think you just cornered the SEO for “conceptual ecophagy”

  2. Jared Woodard Says:

    My core purpose, in fact.

  3. W at Off-Road Finance Says:

    This may just be a perspective issue. Contango IS a problem from the perspective of a long-only long term ETF investor. VXX is about the worst thing they could have in their portfolio. I don’t think there’s a “bonfire of cash” ETF.

    That said, the contango isn’t necessarily distortion. It’s somewhere between a risk premium and a market inefficiency.

  4. Jared Woodard Says:

    Contango / term structure is an inherent cost of doing business. It’s not a market inefficiency except to the extent that human finitude is a market inefficiency.

    No one complains, for instance, that long-dated SPX options are priced at higher IV than short-term options. It isn’t a problem or a distortion or etc., it’s just the natural outcome of the fact that time=money and the future is uncertain.

    VXX, used tactically, can be a very effective hedging instrument – more effective and less expensive than SPX options, for example, as I’ve demonstrated in earlier posts.

  5. W at Off-Road Finance Says:

    I think you’re under emphasizing the size of the contango here. And you have to admit it’s not rate or storage related. This is nothing like say oil future contango. It’s more that the VIX short position legitimately scares the hell out of people. I’m not even sure what sort of portfolio could legitimately contain it in any size. Even the calendar spread seems pretty scary.

  6. Jared Woodard Says:

    It’s all about uncertainty. SPX and any other equity options exhibit similar relationships.

    To say that VIX term structure is a market inefficiency, you would need to show either that a) VIX term structure deviates from SPX curve or b) be willing to claim that the whole listed options market is inefficient in this way. In which case, shh, it’s an arb of world-historical proportions, etc.

    Plenty of people are naked short VIX stuff in various ways, including short term products. XIV is much-loved, for example. No big deal.

  7. Simon Thornington Says:

    I thought the gist of the argument was that VIX ETNs are becoming an appreciable size relative to the liquidity of the futures markets themselves. Given that the VIX Short-Term Futures Index is one that mechanically goes long the second month and then sells as the first month rolls near, a VIX ETN of any size tracking that index will be mechanically steepening the VIX futures curve.

  8. Simon Thornington Says:

    It’s worth pointing out also that I believe normal no-arbitrage arguments are ineffective when dealing with VIX futures vs SPX options — I am fairly sure those two instruments are not economic hedges for one another. This means that one needn’t prove that SPX options are distorted to argue that VIX futures contango is worsened by mechanical ETP steepening.

  9. Jared Says:

    Simon, to your first comment, you’re correct, that is the reason why it’s conceivable that a product tracking SPVXSTR could affect the futures. During the TVIX volume incident, the worry was that TVIX volume was having an influence. But analysis of swap rates – where there is an arbitrage condition – didn’t show any dislocation vs historical norms. I linked to this chart in a previous post on the topic.

    My objection in this post was to the further extension of this argument to VXX. Commentators have been parroting this dislocation claim re TVIX without citing evidence, and are now doing the same for VXX.

    To the second comment – this misses the point. The response above does not depend on SPX options being an economic hedge for VIX futures. The commenter claimed that the existence of contango in VIX futures is something like a market inefficiency. My response is that the term structure of IV in SPX options is similarly sloped. So unless SPX options are also inefficient in this way (which is a rather bold claim to make), the existence of contango in VIX futures is not a market inefficiency.

  10. Simon Thornington Says:

    There was a paper recently about harvesting the risk premium of the roll yield in VIX futures, hedged with SPX. The returns looked worthwhile and robust.

  11. Jared Woodard Says:

    There is this,
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2094510
    though the P/L was flat since mid-2010.

  12. Simon Thornington Says:

    That’s the one!

  13. Jon Says:

    Jared, any futures instrument that has a lot of passive money that is long will suffer from contango. Do you agree with me so far? If not, take a minute to think about it.
    If there aren’t people who aren’t natural hedgers on the other side (short side) of that same contract, there will be contango. The more passive money that must roll each month, the greater the contango will be. Are we in agreement? If not, let me know, and I’ll provide further justification on why this is.
    With the vast amount of money moving into VIX products, who is the party that is taking the other side of the futures trade? If there isn’t someone who wants to naturally be short the VIX futures, then the VIX products are distorting the market by creating contango.

  14. Jared Woodard Says:

    As a registered CTA, I have actually have some passing familiarity with the futures markets.

    Plenty of traders are extremely happy to be naturally short VIX futures, either in the futures directly, in ETPs like XIV, or via options.

    Even if there weren’t natural volatility sellers, the claim that longs were distorting the market requires evidence. One can’t reach that conclusion a priori.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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