Craig McCann's NASAA 2015 Presentation, Investments Through Time
Investments Through Time: The Evolution of Investment Products and How They are Sold.
Crooked Volatility Smiles: Evidence from Leveraged and Inverse ETF Options
Published in the Journal of Derivatives & Hedge Funds 19, 278-294 (November 2013).
We find that leverage in exchange traded funds (ETFs) can affect the "crookedness" of
volatility smiles. This observation is consistent with the intuition that return shocks are
inversely correlated with volatility shocks - resulting in more expensive out-of-the-money
put options and less expensive out-of-the-money call options. We show that the prices of
options on leveraged and inverse ETFs can be used to better calibrate models of stochastic
volatility. In particular, we study a sextet of leveraged and inverse ETFs based on the S&P
500 index. We show that the Heston model (Heston , 1993) can reproduce the crooked smiles
observed in the market price of options on leveraged and inverse leveraged ETFs. We show
further that the model predicts a leverage dependent moneyness, consistent with empirical
data, at which options on positively and negatively leveraged ETFs have the same price.
Finally, by analyzing the asymptotic behavior for the implied variances at extreme strikes,
we observe an approximate symmetry between pairs of LETF smiles empirically consistent with the predictions of the Heston model.
Are VIX Futures ETPs Effective Hedges?
Published in The Journal of Index Investing, Winter 2012, Vol. 3, No. 3, pp. 35-48.
Exchange-traded products (ETPs) linked to futures contracts on the CBOE S&P 500 Volatility Index (VIX) have grown in volume and assets under management in recent years, in part because of their perceived potential to hedge against stock market losses.
In this paper we study whether VIX-related ETPs can effectively hedge a portfolio of stocks. We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs. ETPs which track medium term VIX futures indices suffer less from negative roll yield and thus appear somewhat better hedges for stock portfolios. Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.
We also study the effectiveness of VIX ETPs in hedging Leveraged ETFs (LETFs) in which rebalancing effects lead to significant losses for buy-and-hold investors during periods of high volatility. We find that VIX futures ETPs are usually not effective hedges for LETFs.
The Properties of Short Term Investing in Leveraged ETFs
Published in the Journal of Financial Transformation, Fall 2012, Journal 35.
The daily returns on leveraged and inverse-leveraged exchange-traded funds (LETFs) are a multiple of the daily returns of a reference index. Because LETFs rebalance their leverage daily, their holding period returns can deviate substantially from the returns of a leveraged investment. While about half of LETF investors hold their investments for less than a month, the standard analysis of these investments uses a continuous time framework that is not appropriate for analyzing short holding periods, so the true effect of this daily rebalancing has not been properly ascertained.
In this paper, we model tracking errors of LETFs compared to a leveraged investment in discrete time. For a period lasting a month or less, the continuous time model predicts tracking errors to be small. However, we find that in a discrete time model, daily portfolio rebalancing introduces tracking errors that are not captured in the continuous time framework. On average, portfolio rebalancing accounts for approximately 25% of the total tracking error, and in certain scenarios the rebalancing tracking error could rise to as high as 5% in 3 weeks and can dominate the total tracking error. Since investors in LETFs have short average holding periods and high average turnover ratios, the effects of portfolio rebalancing must be accurately accounted for in the analysis of LETF returns.
The VXX ETN and Volatility Exposure
Published in the PIABA Bar Journal, Vol. 18, No. 24, pp. 235-252.
Exposure to the CBOE Volatility Index (VIX) has been available since 2004 in the form of futures and since 2006 in the form of options, but recently new exchange-traded products have offered retail investors an easier way to gain exposure to this popular measure of market sentiment. The most successful of these products so far has been Barclays's VXX ETN, which has grown to a market cap of just under $1.5 billion. However, the VXX ETN has lost more than 90% of its value since its introduction in 2009, compared to a decline of only 60% for the VIX index. This poor relative performance is because the VXX ETN tracks an index of VIX futures contracts that can incur negative roll yield. In this paper we review the VIX index and assess the opportunities and risks associated with investing in the VXX ETN.
Futures-Based Commodities ETFs
Published in The Journal of Index Investing, Summer 2011, Vol. 2, No. 1: pp. 14-24.
Commodities Exchange Traded Funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging.
This paper examines the sources of the deviation between futures-based commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs.
Leveraged ETFs, Holding Periods and Investment Shortfalls
Published in the Journal of Index Investing, Winter 2010, Vol. 1, No. 3: pp. 45-57.
Leveraged and Inverse Leveraged ETFs replicate the leveraged or the inverse of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.