Funds that track stock market volatility are making a comeback, despite fears that they are too complicated for some investors.
Two new exchange-traded funds that allow investors to make leveraged or reverse bets on a popular barometer of market fluctuations are expected to start trading later this fall. Similar products devastated investors in a massive explosion less than four years ago.
The new funds, managed by asset manager Volatility Shares LLC, were cleared this month for launch by the Securities and Exchange Commission. Both are linked to futures contracts on the Cboe Volatility Index, or VIX, sometimes referred to as Wall Street’s “fear gauge”. One of the funds is betting that the VIX futures will go down, essentially lowering the index. The other is designed to provide double the daily return from VIX futures, which means it can rise sharply when stocks get turbulent.
Some investor advocates have criticized the SEC approval, warning unsuspecting investors could be burned by such products.
“There is very little chance that most investors can really understand how these products work,” said Tyler Gellasch, executive director of the Healthy Markets Association, an investor group that has criticized the list of products with complex volatility. .
The SEC approved both funds after reviewing them for more than a year. Despite the approval, some commissioners remain concerned about fund risks and have called for further study and potentially new rules to protect investors.
These products “can present risks even to sophisticated investors, and can potentially create system-wide risk by operating in unforeseen ways when markets experience volatile or stressful conditions,” the SEC chairman said. , Gary Gensler.
Stuart Barton, co-founder of Volatility Shares, said the company was working closely with the SEC to “come up with a solution that works for everyone.”
The company, founded in 2019, has structured its funds in hopes of avoiding issues that have plagued previous generations of volatility-related investment products, according to regulatory documents.
Volatility Shares products are configured as funds rather than exchange-traded notes. The difference has several implications for investors.
For starters, a fund has a board of directors, like a mutual fund, that oversees it and must act in the best interests of investors. Exchange-traded notes, on the other hand, exist at the discretion of the issuing bank, giving that entity broad discretion to write off or even close a vehicle if it is in the economic interest of the issuer.
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In addition, exchange traded funds have futures contracts based on the VIX. The notes that follow the gauge have a bond created by the issuer, which then typically buys or sells futures contracts to hedge its exposure to the VIX.
Volatility Shares will also use a new approach for the daily rebalancing of the term portfolios of its funds. This is an effort to correct the flaws in older VIX products that contributed to a 2018 collapse dubbed “Volmageddon”.
On February 5 of that year, the VIX more than doubled, with much of the gain occurring in the dying minutes of the trading day. The move caused losses to investors in a popular trade that bet on the VIX going down.
Among the victims was Credit Suisse Group AG
VelocityShares Daily Inverse VIX ETN Short Term. This note had nearly $ 2 billion in assets before the peak. Not only did the note lose more than 90% of its value due to the rise in the VIX, it also fueled the index’s afternoon rise, analysts said.
This was because of the way Credit Suisse rebalanced the futures holdings that underpin the note. The rebalancing took place at the close of the market day, triggering large purchases of VIX futures just before 4 p.m.
In contrast, the new Volatility Shares funds will be rebalanced over a longer period prior to closing. The approach is “reasonably designed to help mitigate” market impact issues, the SEC said in its orders approving the new funds.
Yet Volmageddon remains a cautionary tale for investors. Credit Suisse closed its rating shortly after the episode. And detractors of volatility funds say their use of leverage (amplifying or reversing movements of what is already a volatile underlying index) makes them particularly risky for investors.
“The investor needs to be very careful about what they want to invest in and how they get exposure,” said Henry Timmons, director of ETFs at financial advisory firm Richard Bernstein Advisors LLC, of funds from volatility. “A bit like picking up pennies and pennies in front of a steamroller, it makes a little bit of money most of the time, but you have to be careful not to get run over.
Both Volatility Shares funds remain sensitive to extreme price movements in the VIX, like any other ETF linked to the volatility gauge. In March 2020, when Covid-19 brought down the stock market, the index tracked by the -1x Short VIX Futures ETF of Volatility Shares fell 68%. This year, the index is up about 70%.
Volatility Shares claims that its funds are not suitable for all investors. Cboe Global Markets Inc.,
who manages the stock exchange where the two new funds will be listed, also stressed the need to educate investors.
“Not all products are for everyone,” said Laura Morrison, global listing manager at Cboe. “It’s important to understand the intricacies of each asset class and the risks involved in trading that asset class. “
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