Nick Cherney is cofounder and CIO of VelocityShares, LLC, a company founded in 2009, which develops exchange-traded products for sophisticated traders. Its first product offerings are exchange-traded notes (ETNs) based on the VIX volatility index. He spoke with JLN Options editor Sarah Rudolph about the company and the popularity of VIX-based products.
Q: Could you talk a little about the ETP (exchange traded product) market?
A: The first ETFs were listed over ten years ago and there are now more than 1,000 exchange traded products offered, with over 1 trillion in assets, in the ETP space in the U.S. It’s a huge market — approaching 50% of total US trading volume. So it’s a very deep and liquid market.
Q: Can you tell me a little about your products and the process of creating them?
A: In 2010, we developed our first six products targeting sophisticated investors. Each provides a different variation of VIX futures exposure. Though there is a wide range of investors interested in these products, the common theme is that they are looking for deep, liquid products that provide them with exposures to help manage risk and implement tactical trading strategies.
Our process is informed by the prospective investors in the products, which include hedge funds, proprietary trading shops, investment advisors, mutual fund managers and other institutional investors. Based on their feedback, we build what we think will be liquid and well received. We also do a lot of investor outreach and education to help people understand how to use the products effectively. For example, an investor may understand the features of an option, but may be interested in learning about and developing effective option strategies. Similarly, our products require thorough analysis, and we find that investors are very hungry for education when it comes to implementing effective volatility strategies.
So far the approach has been well received. Of the 13 firms that have launched ETP products in the past year and a half, VelocityShares’s total market share is about 39% for those new products.
Q: What makes VIX products some of the most liquid ETPs launched in recent months?
A: Yes, the first and second most liquid ETPs launched in the last 6 months are both VIX based. In fact, each of them is linked to the same short term VIX futures index. The difference is that one product provides short exposure to that index, whereas the other provides two times long exposure – levered long exposure. The embedded leverage means that if you invest $100, you will have $200 notional exposure.
Both those products are daily-reset products, meaning the leveraged amount resets every night, so it maintains a constant leveraged amount. These types of products have become increasingly popular over the last few years, though they do come with some complexities which investors should thoroughly understand before investing. Complexities such as the characteristics of the underlying indices (i.e. distribution, skew, autocorrelation) and the convexity of daily compounding products, differentiate these products from others.
Of the 300 exchange-traded products listed in the U.S. in the last 12 months, VelocityShares products represent 35% of trading, so the market has clearly accepted them as effective tools.
Q: Why have VIX-related products become so popular in the past few years?
A: It’s largely a function of a shift in investor appetite for risk management. One reason for that shift is the 2008 market crisis. As a result, tail risk hedging solutions in portfolio management have become very popular. Also, there have been innovations in product delivery. VIX ETPs were the first products launched that let people access VIX products without the need to directly trade futures or options. As a result, trading volume in the VIX futures has grown 20-fold in the last couple of years.
Q: Why do spikes in the VIX tend to result in surges in trading volume?
A: It’s highly correlated. Obviously some of that is sentiment-based investing. When you see large market moves in any product you tend to see increased volumes. With the VIX though, you have many people owning long VIX instruments as a hedge, so when the market sells off they want to liquidate those positions. On days when the VIX spikes a lot, people sell the long products and buy the inverse products. The VIX often has dramatic swings, and there is a lot of short term tactical trading around those swings. With the two-times levered product, for example, on a day when the market is down about 160 basis points that product has been up almost 13%. For one day movements, and for short term hedging, it is an extremely efficient vehicle.
Q: Previously, you worked at Barclays Capital in New York and had product development and management responsibilities for iPath ETNs. What did you learn at Barclays from developing the iPath ETNs, which I believe where the first ETNs?
A: Yes, iPath ETNs were the first. We partnered with iShares to launch those first products in the U.S.
I came from an ETF background, and it was obviously a space filled with innovation. The first exchange-traded products in the U.S. were UITs (Unit Investment Trusts). There has been a continuous evolution in product structures over time. The majority of ETFs in the U.S. are mutual fund structures, but we still have UITs and more recently, grantor trusts. Exchange-traded notes are just the newest evolution in that product line. They provide some advantages to other structures and some tradeoffs. They are liquid, efficient, and there is no tracking error, which is important to some product-based investors. They do have some credit risk that is different from the typical ETF. Also, each product is treated slightly differently when it comes to taxes, regulation, and listing rules.
Q: Do the new regulatory requirements in the Dodd-Frank law affect ETNs and ETFs at all?
A: There are not many proposed changes that will affect the current landscape regarding ETNs and ETFs. One area where regulations may affect exchange traded products is the change to the way OTC derivative contracts are treated. That may affect ETNs and ETFs, but there is no specific regulation targeting the ETP industry that I’m aware of.
Q: What prompted you to start VelocityShares?
A: Simply, it was the opportunity to develop products in a way that wasn’t happening in the markets. ETPs are being used as very liquid trading instruments by certain types of investors. We set out to create a firm that was going to target that specific demographic, to develop sophisticated products designed to give institutional investors quality risk management tools.
We’re a relatively small firm that focuses on a rather unique investor base. No other developer of ETPs has taken the same approach as far as tailoring products for prospective investors in those products.