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Investors in a VelocityShares exchange-traded note took a huge hit last week — losing more than 50 percent in two trading days. Ouch!
The sad part is that the loss was perfectly predictable. No one should have been surprised. Still, more than a few folks were blindsided.
Today I will tell you what happened, why it happened, and how you can avoid the same fate for your portfolio.
TVIX Falls Hard and Fast
The loser is called VelocityShares Daily 2x VIX Short-Term ETN (TVIX). I talked about the boom in volatility-based ETFs and ETNs on March 15. Click here to re-read that column if you want a refresher. You’ll notice I did not recommend TVIX or any other ETNs.
As you can see in the chart below, on Wednesday, March 21, TVIX closed at $14.43. The next day it dropped as low as $9.70, and then on Friday ended the week at $7.16. The decline continued into this week with TVIX dropping below $6 on March 26.
The drop had little to do with any change in the underlying VIX index. The built-in 2x leverage wasn’t to blame, either. So why in the world did TVIX drop so hard, so fast?
The quick answer is that the higher price from which TVIX fell was artificially inflated. It never should have been there in the first place! Let’s quickly review how ETFs and ETNs work.
Creation and Redemption
Every ETF and ETN has a market price and a net asset value (also called “indicative value” in intraday data). Market price is what the shares actually trade for, while NAV is what the portfolio is actually worth.
If the market price is higher than the NAV, an exchange-traded fund or note is said to have a “premium.” When the market price is below NAV, it is called a “discount.”
Under normal circumstances, ETFs and ETNs have only a very small premium or discount. This is one of their key advantages, in fact, and is made possible by the ability to “create” and “redeem” shares in large blocks. I explained these facts of life in “Mommy, Where Do ETFs Come From?”
A breakdown in this process is the primary reason TVIX took a tumble, but another factor was closely related. TVIX is an exchange-traded note, not an exchange-traded fund. That means it is a direct obligation of the issuing bank — Credit Suisse, in this case.
(Click here to read my 2009 article, Why ETNs Are Riskier Than They Look. My explanation from back then is still accurate.)
Credit Suisse, announced in February that it would cease issuing new TVIX notes. At that point, TVIX became a broken product. Without the ability to create new shares, there was no way to keep the market price aligned with the NAV. It essentially became a closed-end fund, although many traders were caught unaware.
Why did Credit Suisse stop creating new notes?
The bank cited “internal limits” on the ETN’s size. That means Credit Suisse reached a self-imposed credit limit on TVIX. Without any new notes being issued but demand still very strong, the premium over NAV began to widen — reaching 89 percent at one point.
In other words, TVIX was a train-wreck waiting to happen.
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| This won’t end well. |
After markets closed on March 21, Credit Suisse said it would resume issuing new TVIX shares. With that, the premium to NAV evaporated. TVIX soon returned to more “normal” trading.
What happened within Credit Suisse over those few weeks? The bank had no problem issuing new shares in January, then couldn’t do it in February, and regained the ability in March. Does this make sense?
To me — no, it doesn’t make sense. But my opinion doesn’t matter. Credit Suisse and every other ETN issuer can make its own decisions on whatever basis it wants.
ETF issuers can suspend creation and/or redemption as well. But they have little incentive to do so, since they aren’t borrowing money with every new share they issue.
Lesson: Watch Your Step!
I’ve been around long enough to remember these things happening before …
In 2009 an ETN called ELEMENTS MLCX Gold (GOE) soared as high as 1,000 percent above NAV after its issuer (Credit Suisse again) stopped creating new shares. I warned investors of the impending collapse, and it fell 77 percent over the next few weeks before being delisted.
In early 2011, Market Vectors Egypt (EGPT) built up a substantial premium to NAV when riots paralyzed the country for several weeks. With Egypt’s stock market closed, new shares could not be created and EGPT became a broken ETF. Once again, my warning of the impending premium collapse was proven correct.
And right now iPath Dow Jones UBS Natural Gas ETN (GAZ) is in the middle of taking an even bigger drop than TVIX. Barclays stopped creating new GAZ shares last November, making it a broken product.
GAZ shares were trading at a 100 percent premium last week when a reporter asked me what was happening. The premium reached a high of 163 percent before the story broke.
Shares of GAZ have already tumbled nearly 50 percent from their peak on March 19, but it’s still trading at about a 55 percent premium. This too will eventually collapse. Even if you’re bullish on natural gas, there are better ways to capitalize on the forecast.
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| GAZ will do this soon. |
The storm clouds do have a silver lining. Stories like these get attention because they are so unusual. In almost all cases, ETFs and ETNs can be bought and sold at a very fair price. They are designed to trade efficiently — and usually they do.
Could sponsors do more to protect investors? Yes. Credit Suisse could take a lesson from Deutsche Bank and Invesco. They took the high road in 2009 when the PowerShares DB Crude Oil Double Long ETN (DXO) became so large that it started bumping up against regulatory position limits.
Rather than allow DXO to become a broken product, Deutsche Bank decided to liquidate the notes and returned $600 million to investors. It was a tough decision but clearly the right one.
So don’t be afraid of ETFs or ETNs. Just stay informed and have realistic goals. You’ll find plenty of great opportunities!
Best wishes,
Ron
P.S. I just posted a brand-new video on where the world’s smartest investors are investing their money, including the spot that billionaire Jim Rogers says he wants to put ALL of his! For the full story, I encourage you to watch it — it’s absolutely FREE — but it won’t be available much longer! Just click here to see it before it goes off the air.
{ 5 comments }
I am unclear how you find NAV for GAZ? When I look up quote, I see NAV of 8, but that’s from October, so how do you get a more recent, and obviously lower, number?
The NAV is updated and quoted every 15 seconds while the market is open. The format of the ticker symbol is somewhat dependent on the quote system you are using, but is probabaly one of the following:
^GAZ.IV (for Yahoo and others)
$GAZ.IV (for eSignal and others)
As of this writing, the NAV is $2.14 and the trading price is $3.67 (still at 71% premium).
Thanks very much
So last November Barclays made GAZ a broken product, but your friend Mike recommended to buy them early February. He issued a flash alert to sell just after the peak. Was he just lucky or he knew it was a broken product in risk of collapsing but he recommended it anyhow because he was sure he would play the timing well? and if so, why he did not warn about the risks?
After reading these guys for a while, I bet for the former rather than the latter…
(from Seeking Alpha)
On October 18, 2007 the ELEMENTS consortium quietly launched four ETNs tied to the Roger index (RJI) and three subindexes: Agriculture (RJA), Energy (RJN) and Metals (RJZ).
ETNs are debt-linked products that trade like ETFs. They have marked advantages over ETFs, such as having zero tracking error and having (by most accounts) very favorable tax treatment. However, they do come with credit risk: If the underwriting bank defaults, investors are out of luck.
The Rogers commodity ETNs are backed by the Swedish Export Corp, a quasi-governmental bank from Sweden with an Aa1/AA+ credit rating.