Last year, Steven Hawkins offered the kind of investment you dream of owning: An exchange-traded fund (ETF) that soared by 174.5 per cent as stock markets sailed along serenely. On Monday, that fund was part of a meltdown that took a big bite out of your RRSP.
Mr. Hawkins, president and cochief executive of Horizons ETFs Management (Canada) Inc., watched most of his all-star ETF's 2017 gains evaporate on what he describes as "a completely insane" Monday afternoon, when a sharp, but not unprecedented, downturn knocked the stuffing out of many financial products created to give investors a play on stock price swings. The former market darling, known as the Horizons S&P 500 VIX Short-Term Futures Daily Inverse ETF, was briefly halted on the TSX and then began trading on Tuesday afternoon down 83 per cent from the previous day's price.
The wild ride for Horizons' ETF was symptomatic of a massive problem on Monday, as what Mr. Hawkins called a "frenzy" in a typically obscure corner of the financial world - funds that play on volatility - spilled into mainstream markets. The Dow Jones industrial average fell 1,175 points, or 4.6 per cent, including a gutwrenching late-afternoon plunge that's being directly linked to chaos in products tied to volatility.
Mr. Hawkins says: "Institutions and computer programs were trying to rebalance their portfolios in the face of huge movements in volatility, with hundreds of products affected. It led to a complete dislocation of the market."
The problem on Monday was not the products themselves - Mr. Hawkins correctly describes this particular Horizons ETF as a "high-risk, high-reward asset that's not for the faint of heart."
The problem is the big brains on Wall Street keep coming up with financial instruments - designed for benign purposes such as risk management - that get sold to the masses, then blow up in the face of what seem to be predictable real-world stress.
The 2008 global financial crisis started with problems in mortgage-linked securities that failed when the housing bubble burst.
Monday's sell-off, which seems safely contained after the Dow benchmark rebounded by 567 points on Tuesday, is directly linked to too much money being mindlessly committed to instruments that allowed investors to bet against market swings, which traders wager against volatility, or being "short vol."
As the performance of Horizons' ETF shows, 2017 was a lucrative year to be short vol.
Funds made handsome profits by betting against moves in the Chicago Board Options Exchange's volatility index, known by its stock symbol "VIX" and often referred to as the "fear index."
Late last week and into Monday, the VIX spiked and losses quickly mounted. Many of the hedge funds that short volatility do so with borrowed money: this leverage means they have a low tolerance for trades that go wrong, and move quickly to close money-losing positions.
Christopher Harvey, senior analyst at Wells Fargo Securities LLC, said in a report on Tuesday that "investors reducing short volatility exposure seemed to be the primary driver of the late day slide."
"Monday morning, we told clients that the selloff would likely continue because we hadn't seen the fear. On Monday afternoon, we saw fear and panic as markets became unglued," Mr. Harvey said.
Some volatility-lined funds caught on the wrong side of Monday's move were wiped out.
Credit Suisse Group AG ran an exchange-traded note called the VelocityShares Daily Inverse VIX Short-Term ETN that held US$2.2-billion in assets in early January. The bank is now in the process of redeeming the ETN, leaving investors with significant losses after seeing its value drop by more than 80 per cent in a single day.
For what it's worth, investors were warned of the dangers. The Credit Suisse fund is short volatility - a bet on an endless series of calm days - and leverages returns by borrowing a dollar for every dollar invested. That approach is not suited to market storms. The Credit Suisse prospectus states, in bold letters: "If you hold your ETNs as a longterm investment, it is likely that you will lose all or a substantial portion of your investment."
In hindsight, that's sage advice. Over the past year, markets smoothly moved higher, fuelled by robust economic growth, low interest rates and a geopolitical situation that's remarkably stable aside from the occasional tweet from the White House. Against that backdrop, a fund that makes cash off low volatility seemed to be a great idea. And it was, until the market woke up on Monday to the fact that a strong economy means rates will rise and the world is still prone to political surprises.
Stock markets in New York and Toronto gained Tuesday, though it was the third-straight trading session with wild fluctuations.
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