Some investors in early February got a hard lesson in how ETNs work when Credit Suisse abruptly delisted the VelocityShares Daily Inverse VIX Short Term ETN (XIV). The vehicle made a bet on low volatility, and the index it followed—the S&P 500 VIX Short-Term Futures Index Excess Return—was based on the CBOE Volatility Index, the most widely followed barometer of expected near-term volatility for the S&P 500. The VIX had been near historic lows for some time, but it rose sharply following an unemployment report, and that went against the VelocityShares noteholders. The VIX doubled in value, causing the value of the inverse ETF index to fall by more than 90%. When Credit Suisse delisted the note, it left holders of the XIV vehicle with pennies on the dollar.
Kevin Quigg, chief strategist of Exponential ETFs, says this episode shows that ETNs offer no downside protection for investors, and adds that an ETF would not have suffered the same fate. “If, say, State Street goes under, you're going to be fine because the ETF is backed by the securities and is owned by the shareholders,” Quigg says.
Ben Johnson, director of global ETF research at Morningstar, says ETFs have protections built into them because they’re registered under the Investment Company Act of 1940. ETNs, on the other hand, are registered under the Securities Act of 1933. The latter law calls for very strong disclosures of material risks and says the product should be described in plain English, but it doesn't offer the user protections that the ’40 Act does.
Additionally, the 1933 act stipulates that notes generally can be issued only by large institutions, namely banks, which in part explains why they remain a niche product.
Johnson says investors in the VelocityShares ETN shouldn’t have been surprised at what happened because the prospectus explained how the fund would behave in such an event.
“On the one hand, people probably didn't read the prospectus, and then on the other hand I don't think anyone who was using that particular product necessarily expected that the benchmark index would have effectively declined almost 100% in value in any given trading day,” he says.
An ETN’s terms generally cannot be changed without a high percentage of noteholder consent, says Rishi Rajan, director at Barclays. An ETF’s board of directors, on the other hand, retains discretion over many types of product changes. To make changes in ETNs, issuers need to create new versions.
In April, Barclays changed its ETN lineup. The company streamlined its listed ETNs to 50 from 84, delisting those with low notional values and making structural changes to others by making them callable and lowering expense ratios. The new "Series B" Barclays ETNs track the same underlying indexes as the delisted ETNs.
Who Uses Them, Who Needs Them
Johnson says day traders are drawn to ETNs linked to volatility index products. He says he once estimated the average holding period for the VelocityShares XIV note was about 1.25 days.