Why Not Having to Trade Is a Big Advantage

Two advantages individual investors have is the ability to invest for the long term and to invest in securities with lower levels of trading volume. Many institutional investors do not have these advantages.

In some cases, strategies require trades to be made in undesirable market conditions. Many inverse, leveraged and other short-term exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are at risk of encountering such conditions. Unlike we individual investors who can choose not to trade, some ETFs and ETNs have to trade.

This is what happened to an ETF and an ETN in February 2018 after a sharp jump in the CBOE Volatility Index (aka the VIX). The VIX measures the expectations for future volatility priced into S&P 500 index options.

Here’s what I wrote then about the ETF and the ETN following the VIX’s large move:

We saw the adverse effects of trying to predict how others will react, with two exchange-traded products plunging this week: the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY). Both are bets on traders not paying premiums for protection against higher volatility. Think of them as bets on what other people will pay for insurance against yet other people becoming more skittish. The ETN and ETF worked when the markets were calm, but when volatility returned with a vengeance, their shortcomings were fully exposed. XIV lost 93% of its value and SVXY lost 83% of its value on Tuesday. Both have continued to fall. In reaction, Credit Suisse announced its intention to liquidate the VelocityShares ETN by next week. ProShares sent out a press release saying its ETF’s performance “was consistent with its objective and reflected the changes in the level of its underlying index.”

The third-quarter 2021 issue of the Financial Analysts Journal explains how a feedback loop of required trading and not enough market liquidity led to “volmageddon.” I’ll provide a summary here in lay terms. Even if you don’t trade these types of products, this is a good lesson about what happens when large trades are forced into a market that lacks the volume to handle them.

Both the aforementioned ETN and ETF were designed to realize a daily return of –1 times the VIX. Whatever change in value the VIX incurred on a given day, these exchange-traded products were expected to move by the same magnitude in the opposite direction.

The VelocityShares ETN accomplished this goal by shorting VIX futures (whose value changed in the opposite direction of the VIX). The ETN’s counterbalance was its assets under management (AUM). So effectively, the ETN sought to give investors the daily inverse return of the VIX, while the ETN’s short position in futures contracts allowed it to realize the same daily inverse return. This worked as long as an equal balance could be maintained in both AUM and the short position.

The ProShares ETF differed by selling VIX futures in an amount equal to its AUM. As explained in the Financial Analysts Journal article, “In early February 2018, the value of the SVXY’s AUM stood at $1.7 billion and the fund was short VIX futures with a notional exposure of $1.7 billion.”

They both needed to rebalance their portfolios each day to maintain their –1 times exposure to the VIX.

On February 5, 2018, the VIX surged from 18.44 to 37.32. This big move created a massive imbalance in the ETN’s and ETF’s exposure. (Short positions lose value when the underlying asset, in this case the VIX, rises in value.) To rebalance, both exchange-traded products were forced to buy VIX futures during aftermarket hours when there was less trading activity. This large amount of buying created upward pressure on the price of the VIX, which in turn lowered their value of the ETN’s and ETF’s short positions. This led to even more rebalancing and a dangerous feedback loop for the exchange-traded products.

This feedback loop was the direct result of having to trade in a market without enough volume to support the trading activity. Had they not needed to trade or held less volatile assets—and in turn, avoided facing a forced trading situation—their outcomes would have been different.

We individual investors are rarely in situations where we must trade. This gives us the opportunity to sit tight when market conditions are not conducive to getting our trades executed at or close to quoted prices.

We can also invest in smaller-company stocks. An institutional investor with billions or more to invest will have difficulty acquiring a position in a company with a market capitalization of, say, $400 million. These large investors simply have too much money to deploy relative to the dollar value of shares traded for such stocks. This creates mispricing in small-company stocks. Mispricings are opportunities for us individual investors whose comparatively smaller portfolios make it easier for us to acquire positions in such stocks.

When doing so, keep the trading volume in mind. Depending on the number of shares exchanging hands and the dollar value of trading volume, you may have to split up your trades into more than one order. You may also have to exercise some patience for the order to be filled. Neither is an obstacle for us individual investors because we’re not under pressure to complete a trade within a given time frame.