The Simple Math Behind the Inverse Volatility ETF Collapse

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For the past several years, the stock market has gone through a period of nearly unprecedented calm. Not only did the market move upward sharply, but it did so in a way that had almost no major downward movements along the way. That means those who bet on a continued lack of volatility by using inverse volatility ETFs earned some of the best returns in the market, including a near-tripling in 2017.

That all came to a thundering halt on Feb. 5, and both VelocityShares Daily Inverse VIX Short-Term ETN (NYSEMKT: XIV) and ProShares Short VIX Short-Term Futures (NYSEMKT: SVXY) plunged more than 80% in after-hours trading that day. Credit Suisse, which oversees the VelocityShares exchange-traded note, said on Wednesday that Feb. 20 would be the last day of trading for the volatility-tracking product. ProShares took the opposite course, saying that its fund will be open for trading despite extremely heavy losses.

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The reasons for the moves in the two funds are complicated, but at their core, the failures came from simple math. Most conventional investments have theoretically unlimited upside potential, so that leaves inverse ETFs vulnerable to complete loss of value if the investment they track posts a daily gain approaching 100%.

The unlikely winner of the 2010s

The most interesting thing about these two inverse volatility ETFs is that they were largely an afterthought when volatility-tracking investments first became popular. In the aftermath of the financial crisis, most investors who were interested in volatility wanted to know how to get direct exposure to measures like the S&P Volatility Index (VOLATILITYINDICES: ^VIX), with the idea that they'd be able to cash in on volatility spikes on days like the ones the market saw in early February. That was the basis for the inception of VelocityShares Daily VIX Short-Term ETN (NYSEMKT: VXX), and it wasn't until a year later that the corresponding inverse investment became available.

Yet the 2010s have turned out to be one of the calmest periods of stock market gains in history. Long-time investors in regular volatility ETFs discovered the hard way that the structure of the volatility futures markets that they track steadily eroded their value. That made it critical for investors to be tactical in their approach toward regular volatility ETFs.

By contrast, inverse volatility ETFs benefited from the same futures market characteristics that hurt regular volatility trackers. In the early 2010s, occasional spikes in volatility had enough of an abrupt downward impact on inverse volatility to keep share-price gains from getting too out of hand, but the value of the VelocityShares still jumped fourfold from late 2010 to mid-2015. A pullback in late 2015 cut their value in half, but the VelocityShares then climbed from below $20 in early 2016 to more than $140 by early January.

A sudden end

Yet in the end, all it took was a single day to bring inverse volatility ETFs to their knees. With the VIX having been at extremely low levels, it didn't require too big of a rise to represent a 100% daily boost in volatility. That's what happened on Feb. 5, when February VIX futures rose from their opening level of 16 into the low 30s by the afternoon.

The net result was a plunge in the net indicative values of the inverse volatility ETFs. For the VelocityShares, the closing value of $4.22 per share represented a 96% plunge from its Feb. 2 value of $108.37 per share. Similarly, the net asset value for the ProShares fund went from $103.72 to $3.96 per share.

What's next?

For VelocityShares investors, the clock is running out. Credit Suisse declared what the prospectus refers to as an acceleration event, allowing the company to liquidate and pay investors the net indicative value. That will likely happen on Feb. 21, after a final valuation is determined according to the prospectus.

ProShares, meanwhile, is structured differently, and the loss wasn't quite severe enough to be total. The fund company said:

Going forward, there's little chance either fund will ever recover all of their lost ground. It took years of calm markets to produce the gains that a single day wiped out. Even if the market returns to a calmer attitude, the 25-fold gains it would take to recover from a 96% drop would take decades to recover.

Respect volatility

The lesson that inverse volatility investors learned was that betting against an unlikely event can be profitable for a long time but still be dangerous. After years of success, all it took was one misstep to all but wipe out investors in inverse volatility ETFs, and investors need to be aware of similar risks whenever they look at investments with a track record of success.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool owns shares of ProShares Short VIX Short-Term Futures ETF. The Motley Fool has a disclosure policy.