Exchange-Traded Notes Warning Signs

Investors have been pouring money into exchange-traded notes, ETNs, with the inflows in the first two months of this year being 71% more than in all of last year. Recent developments, however, have underlined some of the risks that investors may face when using these instruments. In several March 29 Wall Street Journal articles, including “Chaos Over a Plunging Note” and “Rise of ETNs Comes with Tempered Enthusiasm,” the tale of a 60% plunge in value in just three days of Credit Suisse’s VelocityShares Daily 2X VIX Short-Term ETN, traded as TVIX, is told. The tale is a complex one, involving a complex instrument meant to track the stock market volatility index, VIX, and that is leveraged to provide investors twice as much as the daily move in the VIX. The SEC and the Commonwealth of Massachusetts are looking into the way this note was managed. We will not go into the details of this case here. Rather we will use it to illustrate why investors should use particular care in considering the addition of ETNs to their investments.

It is important, first and foremost, to understand that ETNs are a form of unsecured structured promissory obligation, backed by the credit of their issuing financial institutions. In other words, the investor is making an uncollateralized loan to the issuing institution. Unlike an exchange-traded fund (ETF), there is no underlying portfolio of securities to which a shareholder can lay claim, should the financial institution declare bankruptcy. This credit risk issue alone has led us at Cumberland Advisors to be very hesitant to use ETNs in our portfolios. We would need to determine first that there was no ETF available that would give us access to the target asset class and, second, that the credit risk involved was minimal.

Furthermore, the case mentioned above illustrates that credit risk is not the only danger. Much of the increased interest in ETNs involves complex instruments for use in hedging strategies. They are designed by sophisticated investment banks and are heavily used by sophisticated hedge funds. Less-sophisticated investors should be very wary of venturing into such waters. As pointed out by Samuel Lee in “Exchange-Traded Notes Are Worse Than You Think” on, “Unlike mutual funds and most ETFs, ETNs are not registered under the Investment Company Act of 1940, or the ’40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures.”

Investors need to read very carefully the ETN contracts, which can include significant unexpected costs. Samuel Lee, points out, for example, the use by some issuers of path-dependent fees that “create tracking error to the index depending on the index’s path.” The result is fees that spike upward most when the index being tracked drops the hardest. This certainly undermines the claim that ETNs are supposed to provide near perfect index tracking. (It should be added here that the VelocityShares ETN, TVIX, cited at the beginning of this Commentary, does not have path-dependent fees.) Other costs that may be encountered in addition to the advertised “investor fee” include “index calculations,” “event risk hedge costs,” “futures execution costs,” and “holding costs.” While touted as a low-cost instrument, an ETN can end up with fees in a range common to mutual funds.

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About Bill Witherell 24 Articles

Affiliation: Cumberland Advisors

William Witherell joined Cumberland Advisors as Chief Global Economist in November 2005 and became a Portfolio Manager in December 2005. He is also a Senior Consultant for Finance and Corporate Governance to the Organization for Economic Cooperation and Development (OECD). From 1989 through September 2005, he was OECD’s Director for Financial and Enterprise Affairs. He joined the Secretariat of the OECD in Paris, France, in 1977.

Dr. Witherell is a graduate of Colby College and holds M.A. and Ph.D. degrees in economics from Princeton University. Dr. Witherell began his career as a business economist with Exxon and Esso Eastern, from 1967 to 1973, where he held positions in the economics, treasury, and corporate planning functions. He moved to the international economic and financial relations field in 1973, with positions first in the U.S. Department of State and then in the Department of the Treasury, from 1974 to 1977, as Director of the Office of Financial Resources and Energy Finance.

Dr. Witherell currently resides in North Grafton, Massachusetts. He is a past Chairman of the International Roundtable of the National Association for Business Economics, and a member of the Boston Economic Club and the Westborough, MA Rotary Club.

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