Exchange-traded notes add another layer of risk

ETNs tied to volatility took a beating when stocks plunged

Feb 7, 2018 @ 2:09 pm

By John Waggoner

The collapse of the VelocityShares Daily Inverse VIX Short Term ETN (XIV) this week should prompt advisers to take a hard look at their clients' holdings of exchange-traded notes.

The ETN was a bet on decreasing volatility, as measured by the Cboe VIX index. For a long time, it was a good bet: The ETN jumped 81.2% in 2016 and then roared to a 188% gain in 2017. Last Friday, the ETN closed at $115.55. Thanks to the roaring volatility since then, it is now trading at about $6.50.

That steep decline taught investors two lessons: First, something that gains 188% in a year is bound to come to earth, and sharply. Second, while ETNs can be used for difficult-to-index investments, such as commodities, they can alsobe particularly dangerous.

ETNs are unsecured debt instruments that are traded on stock exchanges. Unlike traditional bonds or notes, ETNs pay no interest: Their value is tied to an index or some other benchmark, minus expenses.

Like exchange-traded funds, ETNs issue and redeem notes in large blocks. But ultimately, the value of an ETN relies on the creditworthiness of the issuer. In the case of the VelocityShares Daily Inverse VIX Short Term ETN, the value is also controlled by the terms of the prospectus – which, in the case of this ETN, required Credit Suisse to declare a irrevocable call notice after the ETN had lost more than 80% of its value.

For noteholders, that means that they will get the value of the note as of Feb. 15 from Credit Suisse. The call provision isn't unusual.

"They give themselves an out," said Brad Lamensdorf, co-manager of AdvisorShares Ranger Equity Bear ETF (HDGE). "These ETNs are all on their balance sheets, and any bank tangling with that will protect themselves first."

Because of that fact alone, many advisers don't use ETNs, even though the industry offers about 229 ETNs with combined assets of $26.3 billion, according to Morningstar Inc.

"The reason we don't [use ETNs] is from a risk standpoint: You have counterparty risk with ETNs, and we don't need to have that kind of risk," said Steve Janachowski, CEO of Brouwer & Janachowski. "If we want an asset class, we can usually find it somewhere else without adding another element of risk."

In particular bit of irony, those who had shorted VelocityShares Daily Inverse VIX Short Term ETN – that is, bet that the short ETN would fall in price – will have to buy back shares to cover their positions. That may help those who are trying to sell their shares before the fund liquidates.

"With 5.3 million XIV shares shorted, there will be some added trading liquidity for longs looking to sell shares to close out their positions versus shorts buying shares to cover their open short exposure," according to a note from S3 Partners.

The VelocityShares offering isn't the first ETN to have come to grief. UBS initiated a liquidation of ETRACS 2X Monthly Leveraged Long Alerian MLP Infrastructure ETN (MLPL) when the note's value skidded in 2016.

Both the Financial Industry Regulatory Authority Inc. and the Securities and Exchange Commission have issued bulletins about ETNs as well as inverse and leveraged products. Many brokerage houses have banned leveraged and inverse products from their offering, Mr. Lamensdorf said, but added, "RIAs continue to use this stuff."

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