Although the $17 billion exchange-traded note (ETN) market represents less than 2% of the trillion dollar ETP universe, it’s been making a lot of noise.
In late March, the VelocityShares Daily 2X VIX Short-Term ETN (TVIX) lost more than 60% in value in a just few trading sessions, wiping out traders who were making bullish bets on the VIX. They thought they were buying an ETN, but instead wound up with TNT.
Following a similar path (pun intended), the iPath DJ-UBS Natural Gas ETN (GAZ) whose share price is supposed to follow natural gas futures contracts, declined around 40% in value from its March 19 closing price of $6.02. Put another way, GAZ like TVIX took a detour through Hades.
All of this rightly sparks concern about the reliability of ETNs to perform as they were designed. Notes trading at massive premiums or discounts to their share prices isn’t how they were intended to function.
Can ETNs be trusted and should advisors continue using them?
Recipe for Disaster
Depressed stock market volatility thus far in 2012 has pushed the VIX index to 5-year lows. But this isn’t the only contributing factor to the sub-par performance of leveraged long VIX products like TVIX.
TVIX’s issuer, Credit Suisse, stopped creation of the notes on Feb. 21 — causing further instability in its share price. As demand for VIX exposure soared, TVIX’s share price began trading at an 80% premium to the underlying value of its assets.
“Clearly everything would have been easier if TVIX had been able to close to new investors the way a mutual fund can when it encounters capacity constraints, but ETNs and ETFs can’t do that,” said Loren Fox, senior research analyst at Strategic Insight. “TVIX-gate is less about the structure of ETNs than it is about the possibility that the VIX futures market may be too small to support so many assets in VIX futures-related exchange-traded products.”
The VIX is a forward looking tool that measures the expected future volatility of the S&P 500 stock index 30 days into the future.
“An ETN will nearly always track its benchmark in terms of NAV because the issuer of the note is required to match that performance,” said Gary L. Gastineau, author of The Exchange-Traded Funds Manual, 2nd Edition (Wiley, 2010). “In a few cases the ETN market value has temporarily diverged from NAV, usually because of a delay in creations or redemptions.”
Although ETN issuers are quick to laud the benefits of no tracking error or the tax efficiency of notes, issuing and redeeming shares without negatively impacting an ETN’s market price doesn’t always work as expected.
Meanwhile, Credit Suisse and Barclays Bank have been “double dipping” by lending out ETN shares to traders that short them, while simultaneously collecting fees from ETN investors that are long these very products. Not only has this practice ruffled feathers, but it’s gotten the attention of financial regulators.