Details on New VIX ETFs: How VXUP and VXDN Work

Edit 5/21/2015: A follow up article, "The Fatal Flaws of VXUP and VXDN" has been posted.
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On Tuesday next week we will see a new pair of VIX ETFs hit the market: VXUP and VXDN from AccuShares Management. Unlike existing VIX ETPs which move based on VIX futures, these new ETFs will move based on the price of spot VIX.

However, the operation of these funds is not as straight forward as one might expect. I've gone through the 150 page prospectus and have briefly outlined what you can expect from these new products (the full prospectus is available here for those interested in additional details).

Summary

• The Up Class Shares (VXUP) and Down Class Shares (VXDN) are designed to track changes in the price volatility of the S&P 500® Index on a monthly basis.
• The Underlying Index of the Fund is the CBOE Volatility Index (VIX)
• Investors who expect the VIX Index to increase should consider purchasing Up Class Shares (VXUP)
• Investors who expect the VIX Index to decrease should consider purchasing the Down Clas: s Shares (VXDN).

Basic Fund Operation

• The operation of the funds centers on "Distribution Periods" which are marked by "Distribution Dates" (the 15th of each month).
• The primary change in value of the funds is based on the "Share Index Factor", which is reset on each Distribution Date. The Share Index Factor defines how much VXUP and VXDN move for every VIX movement.  
• --> Example: If VXUP is $25 (after distribution) on the Distribution Date, and VIX is at 20, each 1 point (5%) move in VIX is worth $1.25 (5%) to VXUP for the next month.
• Additionally, when the VIX is 30 or less, a "Daily Amount" of 0.15% ($0.0375 in this example) will be deducted from VXUP per day and will be added to VXDN.

Distributions
A primary concept of the funds are periodic Distributions. These will be predominantly done in cash for the first six months, but will be in the form of issuing paired shares of VXUP and VXDN thereafter (depending on the fund's liquidity). Here are the Distribution types:

1. Regular Distributions: Occur on the 15th of each month (the "Distribution Date").
• VXUP will be entitled to a distribution when the VIX has increased between Regular Distributions, or by 75% (“Special Distributions”).
• VXDN will be entitled to a distribution when the VIX has decreased between Regular Distributions, or by 75% (“Special Distributions”).
• --> Exception: Both share classes subject to a maximum of 90% in either direction for a single Measuring period.
2. Special Distributions: Occurs if change in VIX is +/-75% since last Distribution Date. The Shared Index Factor is also reset.
3. Corrective Distributions: Following the expiration of 90 calendar days following the inception of the Fund’s operations, if the closing trading prices of the shares of the Fund deviate from their Class Value per Share by ten percent over three consecutive business days, the Fund will make a Corrective Distribution in addition to a Regular Distribution or Special Distribution on the next scheduled Regular Distribution Date or Special Distribution Date if previously triggered.
4. Other distributions may result from reverse share splits.

Any distributions of cash, or cash and shares, will reduce your exposure and opportunity for gains arising from changes in the Fund’s Underlying Index in subsequent periods. You will need to rebalance/buy additional shares to maintain desired exposure. This concept will be made clear in the example below.

Price Movement Examples:
VXUP will often face a headwind caused by the "Daily Amount" of 0.15%. The table below summarizes the value of VXUP and VXDN for various VIX scenarios after a Measuring Period. Note that when the VIX is +4.5%, the gains in VXUP are offset by the losses from the Daily Amount (since 0.15*30 = 4.5).

In the next table, the VIX is assumed to have moved up 10% from 20 to 22 over 30 days. At the Distribution Date, the result is a 5.5% increase for VXUP and a 5.5% decrease for VXDN based on the combination of the VIX movement and the $0.0375 Daily Amount.

Note that the Fund will distribute a cash amount of $2,750.00 per 1,000 shares of VXUP. The new per share value for each fund is then set at $23.6250.

If instead there is a 10% decrease in VIX from 20 to 18 over 30 days we will have the following:

Here, VXUP will return -14.5% and VXDN will return a total of +14.5% based on both change in the VIX and the effects of the Daily Amount.

It is critical to note that after each favorable movement in a security held, your exposure is reduced due to distributions. In the case of issuing paired shares in lieu of cash, your exposure is still reduced and you would need to sell/buy shares as necessary to maintain a desired exposure.


It is worth highlighting that the Daily Amount only exists when VIX is below 30. When above 30 it is zero so the VXUP headwind goes away.


Supply & Demand and the Arbitrage Mechanism for creation/redemption of share units

• As the Fund’s shares trade intraday, their market prices will fluctuate due to simple supply and demand. 
• An arbitrage mechanism helps to minimize the difference between the trading price of a share of the Fund and its Class Value per Share. Over time, these buying and selling pressures should balance out, and a share’s market trading price is expected to remain at a level close to its Class Value per Share. The arbitrage mechanism provided by the creation and redemption process is designed, and required, in order to maintain the relationship between the market trading price of shares and their Class Values per Share between Distribution Dates.

The facts outlined above cover the basics of these new funds. There are many other additional details and nuances covered in the prospectus which I encourage you to read through if you are considering trading these products.

Bonus: Below I've included some additional risk factors contained within the prospectus that I found to be of interest.

• By purchasing VXUP, investors should have an expectation that the Underlying Index will increase during the period between Distribution Dates. If the VIX decreases during the time between Distribution Dates, investors in VXUP will experience a significant loss and could lose their entire investment.

• The Fund’s Eligible Assets are not managed to provide a maximum long-term return and even a share class experiencing a favorable Underlying Index change can experience losses if the Fund’s aggregate Class Values decline significantly. If the Fund’s aggregate Class Values decline to zero, the Fund’s Up Shares and Down Shares will lose all value, causing a total loss to all Fund investors.

• The Sponsor Has No Experience Managing Investment Vehicles. The Sponsor is recently formed, and has not previously managed any investment vehicles. There can be no assurance that the past experience of the Sponsor’s management team will be sufficient to successfully operate the Fund.