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."


What do you think?

View comments

Recommended for you

Latest news & opinion

RIA in a Box acquired by private equity firm Aquiline Capital

New owners plan more growth for the software service provider.

IBDs with the most female reps

Here are the 10 independent-broker dealers that have the most female reps.

Supreme Court decision likely to prevent brokers from filing class-action lawsuits

However, it likely won't bar employees from filing 401(k) lawsuits against their employers.

5th Circuit denies states' second attempt to defend DOL fiduciary rule

The three-judge panel split again, 2-1, in deciding not to take another look at the motion to intervene by California, New York and Oregon.

Pass-through tax strategies for business-owner clients

Shifting business structure, changing filing status and spinning off equipment are examples of ways business owners can take advantage of the deduction.


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting It'll help us continue to serve you.

Yes, show me how to whitelist

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print