Tuesday, September 3, 2013

Why Do Volatility ETPs Reverse Split?

By Tim Husson, PhD

We still get a lot of questions about VXXTVIX, and all of the other VIX-related exchange-traded products (ETPs).  We've talked before about the persistent loss of value due to negative roll yield, as well as issues surrounding TVIX's suspension of share creations.  We've also talked about some of the newer volatility products that attempt to mitigate some of the issues with the older generation of products.  We've also analyzed whether VIX-based ETFs could serve as a hedge to equity portfolios, and examined persistence and mean-reversion in the VIX and in futures-based VIX ETPs.

One issue we haven't discussed is that volatility ETPs tend to declare big reverse splits, and do so relatively frequently.  Reverse splits essentially reduce the total number of shares outstanding by a certain factor.  For example, in a 2-for-1 reverse split, one new share is issued for every two old shares that are cancelled.  When this happens, the value of each new share becomes twice what one original share was trading at, because each share now represents twice the original ownership amount.

Just last month Credit Suisse announced that it would implement a 10-for-1 reverse split on TVIX and several related volatility ETPs under its VelocityShares brand -- the second reverse split since inception in November 2010.  Why now?  Because since the last split, TVIX's share price has dropped almost 80%:

Source:  Bloomberg

Volatility ETPs lose value over time (Vance Harwood estimates that rate at about 90% per year!), so when the share price gets too low, reverse splits raise it back up to a reasonable trading range.  This is precisely what Credit Suisse did for the last split, which occurred as TVIX started trading under $1 per share.

VXX follows a similar strategy.  Whenever its per share value gets low, it reverse splits:

It is important to note that the reverse splits do not themselves lead to a loss of value -- the loss of value is due to roll yield, compounding, and issues we have discussed before.1  Reverse splits are simply a way of keeping volatility ETPs at reasonable share prices, even as they persistently lose massive amounts of value.  In fact, VXX has lost over 99% of its original value, and yet remains the largest volatility ETP with over $1.5 billion in assets.

1 There is still some disbelief that volatility ETPs can lose so much value without some kind of structural flaw.  Our paper on VXX suggests there is no such flaw (that VXX does exactly what it is designed to do, even if that means losing tremendous amounts of value).  If you don't take our word for it, Robert Whaley, the inventor of the original VIX, has a new paper which says volatility ETPs "are virtually guaranteed to lose money through time."  This was understood even shortly after its inception.

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