Thu, Aug 16, 2012 | Jared Woodard
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.
“Hougan On CNBC: Avoid These Five ETFs,” Index Universe, August 15, 2012