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Can ETNs Be Trusted?

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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.

 Double Dipping

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.

Barclays Capital began lending out shares of GAZ earlier this year even though the ETN was closed to new retail investors, according to a Reuters report. This counteractive move contributed to a decline in GAZ shares, badly damaging ETN investors who were attempting to go long natural gas. Because Barclays wasn’t creating new GAZ shares, but merely lending shares from its own inventory, it wasn’t required to notify GAZ note holders beforehand that new shares would flood the market.

Likewise, Credit Suisse offered ETN shares for lending to its affiliates.

Through such double sipping, Credit Suisse and Barclays Bank were able to charge higher lending fees because shares in the ETNs were in short supply as a result of the fact both sponsors ceased issuing new shares. Traders that shorted TVIX or GAZ made money, while shareholders in both notes got creamed.  

Why would ETN sponsors lend out shares they knew were in short supply to the detriment of their shareholders?

That ETN sponsors would risk damage to their reputations and their businesses to lend shares strongly suggests that ETN issuers, particularly European ones, are badly undercapitalized and desperate for cash. Does that sound like the type of entity to which you would gladly entrust money?

 Will Regulators Step Up?

The ETN industry, like a celebrity in the midst of public scandal, has said very little about the operational problems of its products, instead opting for cryptic behavior and website statements.

Meanwhile, the Securities and Exchange Commission, along with state securities regulators from Massachusetts, are investigating ETNs. Could it be the ETN market is out of control because securities regulators have allowed it to become that way?

The SEC should take clues from the U.S. Food and Drug Administration: When medications available for public consumption don’t perform as they should — or worse, when they hurt people — the protocol is to pull those drugs from the market immediately. And so long as ETN issuers are incapable of preventing their products from trading at massive premiums and discounts or suffering from other operational difficulties, the SEC has a strong case for pulling them from publicly trading markets.

“ETNs don’t necessarily complicate asset allocation, but they may complicate the related process of risk management,” says Fox. “They’re not ETFs, so often they are less liquid than ETFs and they are more likely than ETFs to use complex derivatives.”

Moreover, the very name “ETN” probably doesn’t reflect all of the financial risks these types of products contain. A more apt description for ETNs might be “Debt or Credit Linked Derivatives.”

What should policymakers do? At the very least, a temporary ban would allow regulators to reassess the true risks of these very complicated products.

What should financial advisors do? As the aftermath of GAZ and TVIX sorts itself out, advisors should view these products with high alertness and caution


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