The Fatal Flaws of VXUP and VXDN

Today's post is a follow up to last week's post, "Details on New VIX ETFs: How VXUP and VXDN Work." In hindsight, the title should have included the words "in theory" because the reality of how these funds work is drastically different. The funds are subject to strong arbitrage pressures from VIX futures and will constantly be trading at a premium or discount to the funds' theoretical price, known as Net Asset Value, or NAV (also sometimes referred to as the fund's "Intrinsic Value").

In real trading, the major problem with the concept of these new funds is the presence of a VIX futures term structure that can range +/-20% at times. When AccuShares announced the launch of an ETF that tracks spot VIX, everyone immediately looked forward to getting in on the arbitrage trade to be long VIX and short front month VIX futures during contango. After all, spot VIX and futures converge each month and this trade is essentially free money. The reason for the price difference between spot VIX and futures stems from the principle that VIX is mean reverting. This generally keeps the price of VIX futures higher than spot VIX when VIX is lower than ~20 (the long term average) and VIX futures lower than VIX when VIX is above ~20.

We saw this arbitrage gap close quickly in the first day of trading of VXUP and VXDN. VIX was +0.94% on May 19, while $VXUP was +10.56% and $VXDN was -10.56%. That's not at all tracking towards spot VIX. That is adjusting toward June VIX futures. Such behaviour to price in known information can be expected in a free market when there are obvious pricing discrepancies in what are essentially identical products.

June VIX futures settle on June 17, which is only two days away from the VXUP/VXDN Distribution Day on June 15. Given that the objective of VXUP & VXDN is to track the monthly change in spot VIX (plus an adjustment for the "Daily Amount"), the funds immediately move toward the expected value of VIX on June 15 -- the fair value of which is already agreed upon by market participants by the price of June VIX futures.

There is nothing unique to the month of June that causes these funds to suddenly track at a wide premium and discount to NAV. In fact, the funds will stray from NAV on almost every day in order to account for the value of VIX futures. Generally, the stronger the degree of contango or backwardation the larger the premium or discount to NAV.

It seems that AccuShares (the funds' sponsor) understands these forces, hence the reason for an arbitrary 0.15% "Daily Amount" which is subtracted from VXUP and added to VXDN when VIX is below 30 (another arbitrary threshold). This 4.5% roll yield that was built into the fund operation attempts to mitigate the effects of the contango roll yield. When the VIX futures curve is greater than a 4.5% contango, the only logical purchase is VXUP, leaving no one to buy VXDN.

Using yesterday as an example, an investor looking for protection can either buy June VIX futures at 14.85, or purchase VXUP at a price reflecting a spot VIX of 12.73. If VIX rises to 14.85 by June 17th, the buyer of VIX futures broke even while the purchaser of VXUP gained 11.2% (15.7% minus the Daily Amount of 4.5%). Arbitrageurs are well aware of this and will keep the price of VXUP and VXDN away from their NAV in an amount that reflects the degree of contango or backwardation in VIX futures. VXUP and VXDN will trade at values which close the arbitrage gap, not at NAV.

Today is May 20 and is the second day that VXUP and VXDN have traded. As of yesterday VXUP traded at a 9.69% premium to NAV (which can be tracked here). Today that premium is over 10%. Given that a "Corrective Distribution" is triggered whenever the funds are at a premium/discount of over 10% for three consecutive days it is possible that we'll see triggers often. However, a Corrective Distribution trigger only helps to bring the NAV premium closer to zero as Distribution Day approaches. This does not keep the funds trading near NAV after Distribution Day since the arbitrage gap to VIX futures does not go away.

I had previously thought that the premium/discount to NAV might diminish as the next Distribution Date approached, but it is clear now that if that were the case there would be an immediate and large gap on the following morning, just as we saw on the first day of trading in VXUP and VXDN yesterday. Instead, I expect the premium or discount to be persistently present, depending on the degree of contango or backwardation in VIX futures.

I don't expect the daily movement of these products to track as advertised. I also expect Corrective Distributions to be common as the funds stray 10% away from NAV. This will make the predictability of these funds incredibly difficult for anyone who has not built an arbitrage model.

When it comes down to it, one phrase at the top of the fund's Factsheet sums it up best: "shares of the Fund are intended for sophisticated, professional and institutional investors."

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