A Note on Corrective Distributions for VXUP & VXDN

I've outlined the basic operation of AccuShare's new VXUP and VXDN funds in this post (as they are designed, but not how they'll actually be able to operate). However I did not go into sufficient detail on the topic of Corrective Distributions.

Before I get into that though, I'll mention that AccuShares has already told us that VXUP and VXDN are intended only for sophisticated professional and institutional investors. If you're not in that category you will likely find the following information less useful since you won't be trading these products.

Corrective Distributions are used to help keep the funds trading near their NAV (Net Asset Value). In my previous post outlining the Fatal Flaws of VXUP & VXDN, I explained why it will be common for these funds to trade at a premium or discount to NAV. In fact, as of Friday, VXUP is already trading at a 19% premium to NAV while VXDN is trading at a 17% discount to NAV. Recall that if the closing trading prices deviate from their NAV by 10% over three consecutive business days, the Fund will make a Corrective Distribution on the next scheduled Regular Distribution Date or Special Distribution Date (note: this rule goes into effect only after 90 days since the fund's inception has passed). 

Here's what happens during a Corrective Distribution:
  • First, the Regular or Special Distribution takes place (as outlined in my first post on the topic). 
  • Next, each remaining share will be resolved into a risk neutral position comprised of an equal number of Up Shares and Down Shares, based on the share NAV. 

The key item here is that the value is based on NAV, not the market trading price. Therefore, holders of a security that trades at a premium to NAV will take a loss equal to the amount of the premium on Distribution Day. Likewise, holders of a security that trades at a discount to NAV will see a gain equal to the amount of the premium. 

A Corrective Distribution trigger should help close the gap to NAV in advance of the next Distribution Day so that no such "easy money" can be made/lost. Even the threat of a Corrective Distribution trigger (trading at >10% NAV on the third day) could bring about swift moves towards NAV for each of the funds as traders move to close out positions while the premium to NAV is still double digit percentages, or rush to get into positions that are trading at a large discount to NAV. This pressure may even be enough to prevent the completion of a Corrective Distribution trigger on the second or third day of a threat, resulting in wild daily price action.

After a Corrective Distribution Day I expect the funds to immediately diverge from NAV once again. If the VIX futures term structure is sufficiently steep, the funds will face a threat of a Corrective Distribution trigger again for the following month. This will make it important to constantly keep an eye on the market prices versus NAV and factor these potential events into your trading strategy.

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