The way these inverse funds work is this: Suppose the price of the volatility index you're using is 10. And suppose you have $10,000 in assets in the fund. You therefore have 1,000 contracts in the fund ($10,000/10 = 1,000). The fund will short 1,000 VIX futures contracts to hedge itself.
Now suppose that your index goes up 50 percent in a day, from 10 to 15. Here's what happens: you need to provide investors with a one-day inverse performance of the index. If it goes up 50 percent, the investors lose 50 percent.
The value of your money in this fund has now been cut in half: it's gone from $10,000 to $5,000. But the index is now 15, so $5,000/15 = 333.33 contracts that you now have. But wait a minute: as a fund you are short 1,000 contracts. So you have to buy 667 contracts (worth about $10,000) in order to get to that 333 contracts.
See what happened? These funds had to go into the market after the cl
ose at 4 p.m. Monday and buy a lot of VIX futures contracts.
How many contracts? Jeff Benton, managing director at Fairfield Advisors who has studied the behavior of the funds, estimates that the two volatility funds had to buy as much as 100,000 futures contracts in as little as 10 minutes. This represented roughly 25 percent of the combined average daily volume of those futures contracts, Benton told me.
And that blew up the VIX futures. At the 4 p.m. close, the February futures contract was up 30 percent. The March contract was up 47 percent.
Ten minutes later — at 4:10 p.m. — the February contract was up 95 percent and the March contract was up 114 percent, Benton noted.
That effectively doomed the funds.
At the same time, the S&P 500 futures dropped almost 30 points. Was there a correlation? "It is my suspicion they were reacting to the explosion in VIX futures rather than the 'traditional' other way around," Benton told me. He has a point: there is typically a correlation between volatility and the market. Normally volatility reacts to the market, but in this case it's possible the market reacted to volatility.
I've said this before: if professional traders want to trade these kinds of products, fine. But there were a lot of retail investors who got blown up here, and I don't think the disclosures that they could get blown up will necessarily be enough for regulators.
I think we will see more restrictions on these leveraged and inverse funds in general, perhaps not banning them but restricting them to qualified investors, for example.
These financially engineered products have the risk of unintended consequences. In the case of these volatility-linked funds, they have been doing this for several years without much happening, but in times of extreme stress, strange things can happen.
There's a question whether these funds are a systemic risk. "A product that has a direct translation to equity prices got fairly large, and I think a lot of people did not understand the trigger-type risk it represented," Peter Tchir, a macro strategist at Academy Securities, told me. "I think regulators will see it was a factor in moving markets. This should attract attention."
At the very least, it seems pretty clear that they can make bad days worse.
Here's one final issue to ponder. Smart traders would certainly have known that these funds had to buy VIX futures after the close. Would some have bought ahead of time, knowing they would have willing buyers at any price? Would that have affected the futures prices?
I don't know. I'm just asking.