Ten Things You Should Know About AccuShares’ New VIX UP and VIX Down

AccuShares’ new VX UP and VX Down funds are scheduled to start trading on May 19^th.   There will be a lot of interest in these Exchange Traded Products (ETPs) because they are the first funds to attempt direct linkage to the CBOE’s VIX index.  An investable VIX has been the Holy Grail of volatility investment—it will be exciting to see if these funds can live up to their goals.

I have spent some time reviewing the prospectus.  As usual it is a confusing and frustrating exercise.  I don’t know what it is about prospectus, they seem to give some information eight different times and if you are lucky other apparently critical things are only described once.   I apologize in advance for the likely situation that I’ve gotten some things wrong.

AccuShares states that these funds are intended only for sophisticated investors—I can second that.

The items below seemed important to me:

1. The VIX Up and VIX Down Exchange Traded Notes (tickers VXUP & VXDN) trade in a monthly cycle. The cycle starts on the 16^th calendar day of the month if it’s a business day, or the first business day after.
2. At the end of the monthly cycle the fund with gains distributes a Regular Distribution of a cash dividend or stock grant of equal numbers of VXUP / VXDN shares of equivalent cash value to holders of record. Accushares believes that these distributions will be taxed as qualified dividends.  Usual disclaimers about tax advice apply.
3.  At the beginning of the monthly cycle the value of the two funds is set to the same value—the value of the lower of the two funds at the end of the previous cycle.
4. The funds are designed to follow the percentage moves of the VIX (or the opposite), not the absolute value of the VIX. There may be a 0.15% daily adjustment that will be discussed later.   The theoretical values of the fund’s shares are called the Share Class or the IV values.  The fund’s initial Share Value will be $25 per share.
5. The fund issuer does not make any investments in volatility related securities. All assets are kept in cash or highly secure investments like treasuries or fully collateralized repos.   Earnings from these investments may be distributed as part of the regular monthly distributions.
6. If the VIX index at the beginning of the period is less than or equal to 30 the Up fund’s value is decreased by 0.15% of the cycle’s beginning Share Class value every calendar day (cumulative 4.6% per month). This factor is derived from the typical losses that long volatility products like near month VIX futures or VXX experience in a typical month of trading (a month with no volatility spikes).   The Down shares are boosted by the same amount.  This tweak is intended to prevent disruptive trading by individuals or institutions using VXDN or VXUP to hedge other volatility investments.   Time will tell how well this works.
7. The funds do a Special Distribution if either experiences more than a 75% gain in the Share Class from the start of the monthly cycle. The maximum gain is capped at 90%.  This prevents the losing side from losses exceeding their initial investment at the beginning of the period.   The Special Distribution dividend for the winning fund is essentially the difference between the ending values of the opposing share classes on the Special Distribution date. The next trading day the Up and Down Class Share value will be set to the value of the losing side.  My rough simulation results below suggest that there would have been six such events since 2002, the last one (surprisingly) being on October 13^th, 2014.

8. The Share Class value of the funds will be published every 15 seconds during market hours as the indicative value (tickers ^VXDN-IV & ^VXUP-IV on Yahoo Finance). If the funds are working well the IV prices should be close to, or within the market bid / ask spread.  The difference between the IV value and the traded value of the funds is called the tracking error.
9. If the tracking error of day end trades vs IV values exceeds 10% for 3 consecutive days a Corrective Distribution will be scheduled to be executed with the next Special or Regular Distribution. A Corrective Distribution appears to be a hard reset on the funds, where the fund issuer creates enough additional shares to put every shareholder into a risk neutral position with equal numbers of Up and Down Shares.  Obviously the IV values will have to be adjusted to make this a value neutral event for the shareholder.   Frankly I don’t see how this measure would help a structural problem with fund tracking.  If the fund’s Authorized Participants (APs) aren’t incented to keep the IV and market values close to each other I don’t see how a reset could help.  Perhaps it would improve things for a while but I don’t see how it helps structurally.  AccuShares does not think Corrective Distributions will be necessary.  I hope they are right.
10. The best case scenario for AccuShares is not surprisingly heavy demand for both Up and Down shares. This case would result in increasing assets under management and would likely result in good tracking between IV and market prices.   The worst case would be heavy buy demand for one share type and heavy selling on the other.  In this situation a key difference between VXUP and VXDN vs other Exchange Trade Products comes into play.   Accushares requires that APs bundle equal numbers of Up and Down shares when transacting share creations / redemptions.   This is unprecedented to my knowledge.  Every one of the other 1600+ EPTs has just a single fund involved in the creation / redemption process.  If there is a buy / sell imbalance between these two funds it may become unprofitable for the APs to do the arbitrage transactions that they typically execute that pull trading values closer to IV values.  If this occurs trading and IV values of the funds might become uncoupled from each other—which is a bad thing in the ETP world.

Many a volatility investor has cursed their screens when they have called a VIX move correctly and see their volatility positions barely move, or even go in the opposite direction.  If AccuShares is successful with VXUP and VXDN I expect a flood of money will come their way.