Is Another ETN Meltdown Possible?

It’s been almost one year since the historic collapse of the VelocityShares Daily 2X VIX Short-Term ETN (TVIX). Within a matter of days, TVIX lost around 60% in value, wiping out traders who were making bullish bets on the VIX. What went wrong?

Besides a depressed VIX taking down TVIX, its problem was stoked when its issuer, Credit Suisse, stopped creating shares. This almost immediately triggered further instability in the note’s share price.

Is another blow-up in the ETN market possible?

ETNs Are Not ETFs

Although ETNs and ETFs may resemble each other, they are far from the same. Shareholders in an ETF have a claim on the assets, whereas ETNs are unsecured debt obligations.  That means if the institution who issued the ETN goes bust, it’s likely the ETN will follow suit. This is what’s referred to as “credit risk.”

What about the comparisons of ETNs to traditional bonds?

Unlike bonds, ETNs do not generally distribute any interest payments to investors.

Instead, the issuer promises to pay the ETN owner an amount determined by the performance of the underlying index or benchmark on the ETN’s maturity date (usually two or three decades from issuance), minus any specified fees. As a result, the money invested in ETNs gives issuers a cheap source of capital since they don’t have to pay note holders for assuming credit risk. No wonder financial institutions prefer raising capital via ETNs versus traditional bonds!

Other Risks

ETN credit risk is just the beginning of potential shareholder risks.

Before investing in an ETN, look in the prospectus under any mention of “conflicts of interest.” You’ll be shocked by what you find. For instance, certain ETN sponsors may be allowed to engage in practices that run counter to shareholders, including allowing outsiders to borrow and even short ETN shares. Think twice before investing in an ETN that permits this sort of behavior.

Liquidity risk is another problem. Liquidity risk is another problem. If an ETN issuer decides to delist the note, market liquidity ahead of the delisting can dry up quickly.

Summary

In July 2012, FINRA issued an alert about ETNs, warning about their many dangers. For financial professionals, erring on the side of safety is always a wise choice.

In practice, this would mean deliberately avoiding ETNs in the same investment categories where ETFs are readily available.

For instance, the $5.45 billion invested in the JPMorgan Alerian MLP Index ETN (AMJ) looks especially susceptible, given the questions surrounding JPMorgan’s shaky risk management practices. (See the $6.2 billion “London Whale” trade.)

Investors can get the same exposure to the MLP market via the ALPS Alerian MLP ETF (AMLP), minus the credit risk. Apparently, the $5.45 billion invested in AMJ hasn’t received the memo. There are numerous other examples of where ETFs cover the same asset classes as ETNs.  

I believe another ETN meltdown isn’t just possible, but inevitable.

Today, five of the largest ETN providers are based in Europe. And in case nobody’s bothered to tell you, Europe’s credit crisis isn’t over. This sets up to be the perfect storm for history to repeat itself with more ETN turbulence ahead. Stay ahead of the crowd by avoiding trouble.