TVIX Washout Raises Questions About ETNs

Includes: TVIX
by: Tom Lydon

The risks found in exchange traded notes are in sharp focus following the precipitous plunge in VelocityShares Daily 2X VIX Short-Term ETN (TVIX). its price dropped about 50% in just a couple of trading sessions.

Exchange traded notes have been attracting higher investment inflows alongside their exchange traded fund cousins, but industry observers caution that investors need to take time to differentiate between the two investment products.

The Financial Industry Regulatory Authority is investigating how companies are marketing ETNs, Reuters reported.

FINRA's review is not limited to the TVIX crash, according to the story. "We have a review under way looking at a host of issues relating to ETNs and other complex products," a FINRA spokeswoman said.

Analysts and investment advisors believe that ETN sponsors help fill in gaps in the investment landscape, reported Murray Coleman for MarketWatch. ETNs have brought in $2.4 billion in net inflows so far this year, or 71% more than their overall inflows in 2011, according to Morningstar. ETNs are growing in popularity as a portfolio hedging tool, including products designed to capture market volatility, options strategies and leveraged stock and commodities.

"If someone needs quick exposure to an exotic part of the market that isn't widely available through ETFs, then an ETN can fill a void," Don Martin, president of Mayflower Capital, said. "But they're probably going to remain best-suited to more speculative, short-term oriented traders."

ETNs are unsecured debt instruments that reflect benchmark returns instead of holding the actual shares of securities. If the issuing bank falls on hard times, the ETN can close and leave investors with nothing.

Jason Ware, global market strategist at Albion Financial Group, though, believes that since the index investment isn't restricted to owning actual futures contracts or securities, the ETN product should cost investors less and provide easy access to niche markets.

"The ETN format allows near-perfect index tracking as long as the provider keeps their promise and all the costs are fully transparent," Ware said in the article. "Unfortunately, that doesn't always prove to be the case."

Morningstar analyst Samuel Lee warned that ETNs may not appear as they initially seem. ETNs may include additional charges that add up to expense ratios typically seen in actively managed funds. Additionally, Lee notes that ETNs include instruments that could make the funds diverge from their benchmarks. For instance, after Credit Suisse stopped new issuance on its TVIX ETN, the fund acted like a closed-end fund.

"The risk in dealing with ETNs is that difficult-to-understand cost structures can prove at key inflection points in a market cycle to be a bigger drag on performance than an investor might expect," Jack Ablin, chief investment officer at BMO-Harris Private Bank, said.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.