ETN Investing Can Wipe Investors Out
April 5, 2012
Here is what investors get told, before investing in one set of exchange-traded notes:
* You may lose all or a significant part of your investment in the ETNs if the index decreases or does not increase by an amount sufficient to offset the applicable fees and charges;
* The ETNs are intended to be trading tools for sophisticated investors and should be purchased only by knowledgeable investors who understand the potential consequences of investing in a volatility index and of seeking leveraged investment results;
* The ETNs are not linked to the VIX;
* If you hold your ETN as a long term investment, it is likely that you will lose all or a substantial portion of your investment;
* The market price of your ETNs may be influenced by many unpredictable factors;
If you don't understand what you're buying and you don't understand what you're getting into, avoid this investment like paying off your home mortgage depends on it. Right?
"That says it right there,'' said research analyst Henry Chien. "I don't know what more you can do,'' if you're an issuer like Credit Suisse of heavily structured exchange-traded products, like exchange-traded notes.
The notes in question here are the VelocityShares Daily 2x VIX Short-Term exchange-traded notes, which became a cause celebre in March.
That's because the shares, for a time, traded at an 80 percent premium to their net asset value, by Chien's reckoning, then plunged. Retail investors, trying to capitalize on market volatility, instead got caught in it. The Securities and Exchange Commission says it's investigating, as does the Financial Industry Regulatory Authority, the overseer of broker-dealers.
Credit Suisse, for its part, says it's cooperating with investigators. But otherwise is not commenting.
But those warnings that start on the first page are in the product pages that summarize the characteristics of these particular VelocityShares notes, in the registration statement filed in December 2010 with the SEC. And sitting in plain sight on the Credit Suisse site, for any investor that wants to see what the characteristics of the investment in these notes involves.
A good warning flag, for instance, might just be that the very first risk listed is that an investor "may lose all or a significant part" of an investment if the index on which it is based drops.
A second strong flag would be that a note that actually bases its drawing power on the fact that it is a "Daily 2x VIX Short-Term ETN" and in the same breath notes that is "not linked to the VIX" is probably worth stopping an investment in its tracks, if the investor thinks that somehow the note actually has a direct link to the VIX. Or, more pointedly, generates a return that is "2X' the movement of the VIX.
The VIX, of course, is the Chicago Board Options Exchange's index of the swings of stock markets. The Volatility Index. The Fear Index. The thing that has pretty much made the CBOE a hot venue for contracts that bet on future movements of the Standard & Poor's 500 stock index.
But the VelocityShares Daily 2x VIX Short-Term ETN instead is an investment in a debt obligation of a bank. These notes are "senior, unsecured obligations of Credit Suisse AG acting through its Nassau branch. The return on the ETNs is linked to twice the daily performance of the S&P 500 VIX Short-Term Futures Index less the investor fee.''
Translate: If something goes wrong, your investment is "unsecured," or probably worthless. The investment is "linked" to some sort of short-term index of future movements of the VIX. But not the VIX itself.
The nut nut: Only professionals need apply for these exchange-traded notes.
And even they could get caught in the damage, when unexpected events actually do come about.
On February 21, Credit Suisse, as it notes in its amend ed prospectus for these notes, "temporarily suspended further issuances of the 2x Long VIX Short Term ETNs due to internal limits on the size of ETNs." The apparent meaning: That it could not issue more shares, without crossing its own 'internal limits' on holdings of a particular security or affecting the underlying value of the obligations themselves.
That drove up the value of the notes, to the surprise of Morningstar exchang-traded product analyst Timothy Strauts.
"Logic would tell you it would go to a discount,'' he said, because the amount of shares being created did not meet demand. "Unfortunately, that was not the case.''
Instead, demand for a scarce product pushed up the price far beyond its asset value, Chien noted. Which reflects basis supply-and-demand economics.
That led to the bubble that burst, in fairly short order in March. And the investigations of how investors got hurt.