Credit Suisse VIX Note Decline Highlights Investor Risk
The plunge of an exchange-traded note backed by Credit Suisse Group AG highlights the growing risks for investors in some of Wall Street’s most complex exchange-traded products.
The VelocityShares Daily 2x VIX Short-Term ETN (TVIX), which seeks to provide twice the daily return of the VIX volatility index, fell 30 percent on March 23 after Credit Suisse said it would begin issuing new shares. The Zurich-based bank stopped creating shares a month ago, unhinging the fund’s price from the index and leading to a premium over the indicative value that peaked at 89 percent on March 21 before plunging to about 7 percent two days later.
“This is a wake-up call,” Samuel Lee, an analyst with research firm Morningstar Inc. (MORN), said in a telephone interview. “People don’t take seriously the options that issuers have” that can cause ETNs to suddenly stop behaving as they are intended.
Exchange-traded products, or ETPs, have grown into a $1.7 trillion global industry, attracting more than half of all U.S. fund deposits in the five years through Dec. 31, as investors sought an easier way to track indexes with lower fees than active funds. The funds have come under scrutiny over whether they might represent a broader risk to financial markets, and whether investors understand how those funds work that use derivatives to produce returns.
Most ETPs in the U.S. are exchange-traded funds, which track an index by holding the underlying securities. These include the biggest ETF, the $102 billion SPDR S&P 500 ETF Trust, which seeks to replicate the performance of the Standard & Poor’s 500 stock index.
ETFs issue shares that trade on an exchange like stocks, and can create new shares or redeem existing ones. Exchange- traded notes, or ETNs, like the one backed by Credit Suisse (CSGN), by contrast, issue unsecured securities that promise to deliver the return of an index. The issuer, often a bank, typically uses derivatives linked to the index to cover their obligation to shareholders. If the issuer cannot repay the notes, investors lose their money. Issuers may also decide to stop creating or redeeming shares, unhinging the ETN from the security or index it was designed to track.
BlackRock Inc. (BLK), the world’s largest ETF provider, has urged regulators to enforce clearer labeling rules and risk disclosure requirements to help investors differentiate between products that are often lumped together under the ETF name.
Laurence D. Fink, chairman and chief executive officer of the New York-based firm, in October compared the development of increasingly complex exchange-traded products to the evolution of mortgage-backed securities that ultimately helped cripple financial markets in 2008.
“Examples like this support what we’re trying to do around regulatory reform and the education of investors about exchange- traded products,” Jennifer Grancio, head of U.S. distribution for BlackRock’s iShares unit, said in a telephone interview, referring to the Credit Suisse ETN. (GAZ) “All exchange-traded products are not created equal.”
Investors, who bought the ETN to profit from rising volatility, lost about $340 million when it dropped more than 50 percent over two days. The plunge began even before Credit Suisse announced on the evening of March 22 that it would resume issuing shares.
The initial drop reflected short selling amid speculation new shares would come into the market after the ETN climbed to record premiums, said Chris Hempstead, director of ETF execution service at WallachBeth Capital LLC in New York. Less sophisticated investors who didn’t anticipate the move were left with the losses.
In a short sale, an investor borrows a fund or security, then sells it, betting the price will fall and the security can be repurchased later at a lower price.
When Credit Suisse stopped issuing TVIX shares temporarily in February, it cited “internal limits on the size of the ETN.” The product’s prospectus tells investors the issuer is “under no obligation to issue additional ETNs to increase the supply.”
Jack Grone, a spokesman for Credit Suisse in New York, declined to comment.
Issuers stop adding shares, Morningstar’s Lee said, when they reach a limit on their derivative positions imposed internally or by an exchange or regulator. At that point, the issuer is no longer assured of delivering the targeted return without incurring a loss.
“The industry as a group makes the argument that they are only dealing with sophisticated investors who read prospectuses and understand the risks,” Lee said of ETN providers. “This is sort of a fantasy world.”
Steven Cohen, 47, a packaging consultant in Denver, bought 2,000 TVIX shares in two batches on the morning of March 22, predicting a rise in the VIX, which went up that day 2.9 percent. Instead of seeing the TVIX’s share price jump about 5.8 percent, as Cohen expected, it dropped 29 percent.
By the time Cohen sold all his shares on Friday, he’d lost $6,490 on an initial investment of $24,640.
“It should have been up and I would have been out of it,” Cohen said in a telephone interview, “They changed the rules without letting anyone know. How do you just continue offering the ETN in the market like nothing ever happened?”
Cohen, who said he has traded in and out of the note more than 10 times since September, said he filed a formal complaint with the Securities and Exchange Commission.
ETPs have come under scrutiny over several issues since 2009. The SEC examined whether they contributed to equity-market volatility in 2010 and the 8.6 percent intraday plunge in the Standard & Poor’s 500 stock index on May 6, 2010, known as the “flash crash.” The International Monetary Fund said last year that European ETFs that generate returns through derivatives, so-called “synthetic” ETFs, add a layer of complexity and risk to financial markets.
Max Breier, a senior equity derivatives trader at BMO Capital Markets Corp. in New York, said he believed regulators would re-examine ETNs in the wake of last week’s incident.
“It highlights that it’s kind of a dangerous instrument,” Breier said. “As long as there’s this creation - halt to creation game being played, it becomes an extra factor that you have to look out for when you’re getting involved in this product.”
John Nester, an SEC spokesman, declined to comment.
In addition to representing an unsecured debt, TVIX presented complexities because it tracked an index that many investors may not understand. It also added leverage to amplify the moves of the underlying index. The Financial Industry Regulatory Authority warned in 2009 that such products might not be a good fit for long-term investors.
“I don’t want to say we need to have strict regulations, saying that only qualified or sophisticated investors like hedge funds can get into them, but there’s got to be something,” Colby Wright, assistant professor of finance at Central Michigan University, said in a telephone interview. “Retail investors are going to get their clocks cleaned if we keep letting them do this stuff.”
TVIX is not unique in having suspended share creations. U.S. Natural Gas Fund temporarily stopped adding new shares in 2009 because of limits on energy speculation. Barclays Plc (BARC)’s iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN also stopped issuing new shares in 2009. It currently trades at a premium of 86 percent, highest among 208 U.S. ETNs, according to data compiled by Bloomberg.
BlackRock, as part of a distribution agreement with Barclays, is paid to help sell the ETN. Grancio said the firm only promotes the product to institutional investors.
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