The fantastic collapse of exchange-traded notes or "ETNs" linked to the VIX and natural gas has captured the imagination of everyone from day traders to soccer moms – and now – securities regulators.
In late March, the VelocityShares Daily 2X VIX Short-Term ETN (NYSEArca:TVIX - News) 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 (NYSEArca:GAZ - News), which is supposed to follow natural gas futures contracts, has declined around 39% in value since its March 19 closing price of $6.02. Instead of closely tracking its natural gas benchmark, GAZ has taken a detour to Hades.
Any cockeyed ideas you can dream up and there's probably an ETN tracking it. Some ETNs promise leveraged long gold exposure (NYSEArca:UGLD - News), leveraged short gold exposure (NYSEArca:DGLD - News), leveraged long oil exposure (NYSEArca:UOIL - News) and leveraged short oil exposure (NYSEArca:DOIL - News).
ETNs are debt instruments issued by banks or financial institutions that can be linked to stock, bond, and commodity indexes along with currencies.
As a result huge discrepancies in the share price of these ETNs and the value of their underlying assets, the ever tardy Securities and Exchange Commission (SEC) along with state securities regulators from Massachusetts are now investigating ETNs. What took them so long? Why didn't the SEC investigate the iPath DJ-UBS Natural Gas ETN three years ago, when Barclays stopped issuing shares in August 2009? What about February 21, 2012 when Credit Suisse stopped creation of TVIX notes causing further instability in the share price? Why didn't the SEC immediately open up investigations back then?
And why has the SEC allowed financial marketers the freedom of naming rights? In truth, the very term "ETN" is a false marketing label that piggybacks on the popularity of exchange-traded funds or "ETFs." Why hasn't the SEC banned this misleading name? Does the ETN label accurately reflect all the financial risks of the product? A more apt description for ETNs might be "Debt or Credit Linked Derivatives." (Personally, I prefer TNT.)
Popular for the Wrong Reasons
"Structured investments" have been issued by brokerage firms since the late 1980s and are the history of where ETNs began. These products are like financial burritos that use derivatives such as options or swaps to follow a specific investment strategy. Like chameleons that can quickly change their identity, there is no single or uniform definition of a structured product.
Structured products were not invented to help investors as industry types like to argue, but to help companies issue debt more cheaply.
Today, four of the five largest U.S. ETN issuers are European banks. And although all may seem calm, European banks are badly undercapitalized. Is it any wonder why new ETNs have been flooding the U.S. marketplace? Faced with increased borrowing costs and the need for more capital, Eurozone banks need their money fix. And increasing the issuance of structured products or ETNs is like a quick and easy withdrawal from an ATM machine. ETNs allow banks to borrow billions of dollars from retail investors without compensating them for surging credit risk.
The other reason ETNs are popular with issuers is because the time from laboratory to market is much shorter compared to ETFs.
Asleep at the Wheel
The ETN industry, like a celebrity in the midst of public scandal, has said very little about the defects in their products, instead opting for cryptic behavior and meaningless Website statements.
The $17 billion U.S. ETN market is out of control because securities regulators have allowed it to become that way. Why doesn't the SEC act in the best interest of the investing public by banning ETNs? At the very least, a temporary ban would allow regulators to reassess the true risks of these very complicated products.
The SEC should take clues from the U.S. Food and Drug Administration (FDA): When medications available for public consumption don't perform as they should – or worse – when they hurt people, the protocol is to immediately pull those drugs from the market. ETNs are equivalent to very dangerous drugs with unpredictable side effects. 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, these products have no place in the public markets.
In the December 2011 edition of the ETF Profit Strategy Newsletter, I warned "Which ETNs Will Blow Up First?" In this research piece, I provided a list of the top 15 ETNs by assets and 15 better alternatives. (Incidentally, TVIX was one of the ETNs advised against.) While others were cheerleading ETNs, we gave our subscribers advanced warning about the financial dangers of these products.
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