One Of The Creators Of The VXX Explains The Problem With Many Volatility Products

Michael Schmanske doesn’t blame creative or contrived innovation for the financial markets’ extreme, multi-session volatility. He blames ignorance.

“Some of these [market-levered products] should have a skull and crossbones attached to them: ‘these products will kill you if you don't know what you're doing,’” Schmanske, founder and senior portfolio manager of Glenshaw Capital, said Wednesday on Benzinga’s PreMarket Prep radio show.

How To Trade Volatility

While at Barclays, Schmanske oversaw the launch of volatility products like iPath S&P 500 VIX Short Term Futures TM ETN VXX and iPath S&P 500 VIX Mid-Term Futures ETN VXZ. He designed them, and he knows how to trade them.

But not everyone does. Schmanske attributed this week’s market quakes to misuse of the volatility product, which was intended for short-term trades around the existing market structure rather than any long-term investing.

"When we created the VXX, it was always designed to be more of a trading vehicle than a ‘buy and hold,’” Schmanske said. “It was meant to be a portion of a dynamic allocation strategy more so than something that people would just trade into and just hold for a long term.”

Related Link: What Is The VIX, And What Does It Do?

What’s Gone Wrong

The unexpected investing strategy set the stage for problems in products like Credit Suisse AG - VelocityShares Daily Inverse VIX Short XIV, which is consequently being prematurely liquidated.

“The problem with your XIV and the other levereds is they’re always daily resetting, and there's always the potential that they can blow up on you,” he said, noting that the XIV imploded “not because it necessarily is a bad trading vehicle, but because the internal algorithm for it dictated that it needed to be stopped out.”

By Schmanske assessment, early volatility products, those in the form of, say, structured notes, “kind of missed the point” and have been confused with and distorted by newer products meant for active management to create yield.

“If you look at the VXX from its inception to now, it's down something like 99 percent, because the point is you buy it in order to own insurance,” Schmanske said. “Insurance isn't something that pays out unless there's a crisis.”

Check out the full interview in the clip below.

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