Mind the Gap | Hidden problems and greed explain why these ETFs mysteriously shut down

Easy come, easy go. That’s the only way to describe the end of easy returns selling low volatility for years after recent sharp market declines and high volatility. Selling volatility in a market that had been steadily rising was one of those sure things made easier by information and execution technology and exotic products such as leveraged and unleveraged exchange traded funds (ETFs).

The popularity of alternative risk premium products has steadily grown in response to nine years of negative to low interest rates. Many of these securities are bundled with attractive names like ultrashort, double long or inverse. They benefit from the transparency associated with other ETFs, sound regulations, public listings and specialised index tracking supported by reputable institutions.

“Movement in the VIX index was not random and the size of the positions being moved caused a cascade. This move was caused by portfolio re-hedging and rebalancing and algorithms reacting to market signals,” said Tobias Bland, CEO of Enhanced Investment Products. “For a long time, selling volatility for more yield in a low yield environment was a free lunch, but no more.”

This is being unwound as the leverage behind those trades are being deleveraged. Since 2009, this leveraged risk became longer duration, more risky, more illiquid as investors sought higher returns.

The bet went so awry that the ETFs’ termination clause was triggered to close the fund when the notes lost more than 80 per cent of their value during the market drop. The termination clause allows the manager/underwriter/market maker of the fund to wind it down. After all, a fund with a negative NAV puts the manager in the odd legal position of owing investors money. But, like most prospectus terms, no one pays attention until something bad happens.