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A Lesson in the Danger of ETNs

All exchange-traded products are not created equal.

The most popular exchange-traded products are exchange-traded funds (ETFs), which are basically mutual funds that trade on an exchange like a stock. Then there are exchange-traded notes (ETNs), which were first offered in 2006 by Barclays. ETNs are debt securities, usually issued by an investment bank, that trade on an exchange during the trading day. ETNs basically combine the features of a bond and an ETF. But what might look like a plain vanilla investment has hidden complications.

The difference is that an ETF holds an underlying investment, but an ETN is an agreement by the issuer to pay its shareholders. So when you buy an ETF, you are buying a slice of a portfolio…again, similar to buying a mutual fund. But when you buy an ETN, you are buying the promise of a payment of debt. Even more to the point, you are buying the promise that the issuer of the ETN will pay off that debt according to plan.

But the debt is unsecured, and there are no guarantees made by the issuer. There is no principal protection… all you’ve got is a promise.

ETNs are complex products, and they are risky by nature. The markets reminded us of that recently. The Velocity Shares Daily 2x VIX Short-Term ETN (TVIX) is an ETN that is meant for investors who want to profit from volatility in the market. The note is designed to provide twice the daily return of the VIX volatility index.

On March 22, the Velocity Shares Daily 2x VIX Short-Term ETN (TVIZ) fell 29%. And the next day it fell another 30%. And over those two days, investors lost $340 million.

The trouble started in February, when the note neared $700 million in assets, and became too big for the market it was tracking. So on February 21st, Credit Suisse halted the issuance of new shares “due to internal limits on the size of ETNs”. And with that, the company warned that the halt “may cause an imbalance of supply and demand”.

And when issuers choose to stop creating or redeeming shares, the ETN is disconnected from the index it was meant to track…so while TVIX dropped almost 60%, market volatility was little changed.

Hedge funds are typically the most active traders of ETNs. And hedge funds were a step ahead of the trouble with TVIX. After Credit Suisse stopped issuing new shares, hedge funds started to bet aggressively that shares would decline. Meanwhile, individual investors were sitting ducks who got cleaned out.

TVIX tracks an index that many retail investors may not be entirely clear on, and it amplifies the moves of that index. That means TVIX is not for everyone, and because it uses leverage to magnify returns, it’s not a long-term investment. But to be fair, the prospectus warns investors that the ETN is a trading tool “for sophisticated investors to manage daily trading risks” and that it “should be purchased only by knowledgeable investors who understand the potential consequences of investing in volatile indices and of seeking inverse or leveraged investment results”. It also says that shares “may not be suitable for investors who plan to hold them for longer than one day”.

TVIX “is a wake-up call”, according to Morningstar analyst Sam Lee. He warns that issuers have options that will cause ETNs to stop behaving the way they were meant to behave very quickly. In the case of TVIX, that very quickly amounts to losing 60% in 48 hours.

The trouble with TVIX is it’s a wake-up call with a red flag attached to it. ETNs are not always what they appear to be on the surface…and if investors aren’t even going to thumb through a prospectus looking for a warning, then they probably shouldn’t invest in one.


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