you are probably aware of the carnage in the $TVIX 2x VIX ETN issued by Credit Suisse. In this morning’s WSJ an article titled Chaos Over a Plunging Note reports that now the SEC is looking into the behavior of this ETN which supposedly had $700mm in assets.
The scrutiny comes amid rising investor alarm and confusion over trading in exchange-traded notes. The Credit Suisse note, which trades as TVIX and is designed to track stock-market volatility, plunged 29% on Thursday last week and then another 30% on Friday, even though market volatility was little changed. Another exchange-traded note, a Barclays Capital product designed to track natural gas, plunged this week for reasons that investors say remain unclear.
Without knowing the exact composition of the $TVIX I have a pretty good idea of why this thing is blowing up and the same dynamic is present in all levered ETFs. It’s called negative gamma.
What is gamma and more importantly what is negative gamma?
According to my options handbook, Option Pricing & Investment Strategies written by risk management guru Richard Bookstaber who also wrote A Demon of our own Design: The gamma of an option measures the rate of change in the delta of the option as the underlying security price changes.
I think of gamma as the volatility of volatility. Gamma is also akin to the convexity of a bond. In a positive or long gamma position you gain more exposure to price as it moves in that direction, i.e. you get longer as price goes up and shorter as price goes down. In a negative or short gamma position you gain more exposure to price as it moves in the opposite direction, i.e. you get longer as price goes down and shorter as price goes up.
So in a levered ETF the managers have to rebalance everyday to maintain the leverage ratio. This causes managers to buy more as price goes up and sell more as price goes down, hence the negative gamma. It’s amplified when the managers are using derivative instruments which also have embedded gamma risk.
Many of the great market blow ups in recent history have been the result of negative gamma blow outs. The portfolio insurance behind 1987 was a negative gamma blow out. Orange County and LTCM were short gamma. CDOs and other structured products are also short gamma. We believe one of the main catalysts behind the 2010 “flash crash” and last year’s August crash were driven by negative gamma blow outs in levered ETFs.
In order to identify the next accident investors need to be cognizant of large negative gamma positions and catalysts that can force a blow out. We believe one of the largest concentrations of negative gamma is in the bond market. Recall we compared gamma to convexity of a bond. Callable bonds, because they are short a pre-pay option exhibit negative convexity. This means that bonds are short volatility in that they prefer a stable and low volatile rate environment. Negative convexity bonds under-perform positive convexity non-callables when rates fall and when they rise.
The main risk behind the QE program, in addition to devaluing the reserve currency, is the Fed has essentially allowed the Treasury to plug the bond market with loads of low/negative coupon long duration assets. The lower the coupon for a given duration means the higher the volatility and that would be magnified for callables in a rising rate environment as they become de facto bullets (call option goes to zero). This is called extension risk. As rates rise, your bond lengthens in duration and thus you become longer as price goes down, hence the negative gamma.
The bond market has always been comprised of negative convex product and that is not what concerns us per se. What concerns us is 1) the rising percentage of low coupon long duration assets to total stock, 2) the exposure of the banking system, insurance companies and pension funds to these securities and 3) the recent massive asset allocation shift from retail accounts out of equities into fixed income.
If there is an accident waiting to happen we don’t see it in the stock market that no one owns, we think it’s in the bond market and the massive embedded risk of negative gamma. We are pretty sure most who have sold equities to pile into fixed income over the past couple of years at negative coupons are totally unaware of negative gamma risk. In fact we believe their position in “risk-free” government backed assets are potentially the riskiest asset on the board.
So what’s the catalyst? See the Triffin Dilemma: the conflict between the benefits and costs of a country with a reserve currency running a large current account deficit. The reserve-currency country enjoys the consumption benefit of running a trade deficit, while the rest of the world benefits from the additional liquidity, which helps facilitate trade, The cost comes from the declining value and credibility of any currency which runs a persistent trade deficit – eventually leading to a reluctance of creditors to hold the reserve currency.
It might be happening….