ETF Investors: Beware The Coming ETN Backlash (TVIX, GAZ, UVXY, UNG, UNL)
Eric Dutram: The broad ETF industry has seen its share of controversy over the past few years thanks to a number of issues. These misunderstandings have undoubtedly hurt the ETF world and have probably pushed some investors into other products as a result, diminishing an otherwise solid period for the exchange-traded world.
One of the first issues that has probably stuck in investors’ minds regarding ETFs has been the leveraged fund ‘controversy’. Many investors failed to realize—or understand—how products that reset on a daily basis differ from monthly resetting funds and how this distinction can impact returns. In an oscillating market, returns from a levered ETF are likely to deviate significantly due to this rebalancing and compounding issue, leaving some investors who have failed to grasp this nuance scratching their heads (for more on this read Understanding Leveraged ETFs).
More recently, ETFs have been at the center of the flash crash according to some analysts. People who subscribe to this idea seem to believe that the product structure of funds somehow caused the crash. However, other analysis shows that high-frequency trading done by algorithms likely caused the May 6th debacle in 2010.
Beyond these issues, ETFs have also faced scrutiny from a variety of other market participants who blame ETFs for everything from high commodity prices and asset correlation levels, to even bizarre claims that ETFs have somehow hurt the IPO market.
The reasons for these claims are numerous and I doubt that we will see a shortage of them anytime soon. In many cases, mutual fund issuers have quite a bit to lose from the rise of the ETF world and have sought to discredit the ETF industry at every turn. Other times, such as in the case of the leveraged ETF world, it appears as though lawyers are just trying to make a quick buck off of investors who didn’t really do their homework about the products they were getting themselves in to.
While most of these issues have fell by the wayside as investors slowly realize that ETFs aren’t really to blame for most of the world’s ills, new PR problems seem to be hitting the market all the time. Now it appears as though the next trouble spot will be in terms of Exchange-Traded Notes, which have found themselves increasingly under fire as of late.
ETNs vs. ETFs
ETNs are like their ETFs cousins but there are a few key distinctions. ETNs do not actually invest in securities; instead they operate as senior unsecured debt obligations of their issuers. This means that ETNs promise to pay out a return that is equal to their underlying indexes, a strategy that can get rid of tracking error, especially when compared to ETFs.
The downside to this is that investors take on the credit risk of the issuing institution meaning that if a major bank goes belly-up, investors may not receive their investment back. This is unlike ETFs where the issuing institution doesn’t really matter; investors have the actual shares of a company or bond in their basket.
Possibly due to this credit risk, ETNs haven’t really caught on with investors and remain a thinly traded product. In fact, of the 100 most popular ETPs by assets under management, only two are ETNs, demonstrating just how far the space has to go to catch up to their ETF counterparts (for a more in depth discussion read ETFs vs. ETNs: What’s The Difference?).
This problem could be further compounded by some ‘trading issues’ in a few ETNs as of late. While none of these products are inherently flawed, they could all cause investors to pause before purchasing ETNs again in the future.
That is because both were—or still are—trading at significant premiums to their NAV. This means that the assets in each unit of the note are worth less than what they are trading for on the open market. Generally speaking, this is a result of the ETN issuers refusing to put out more shares on the open market which can create a disconnect between underlying prices and the share price of the note.
This problem usually doesn’t happen in either ETFs or ETNs as issuers and market makers are incentivized to keep the number of shares in balance with the total assets in ETFs. Usually, when products develop a premium or discount, market makers step in to try to make small profits on the discrepancy. However, when an issuer suspends further creation baskets from being made, prices can get out of whack and investors can see issues like in the both ETNs highlighted below:
VelocityShares Daily 2x VIX Short Term ETN (NYSEARCA:TVIX)
This ETN looks to track two times the daily performance of the S&P 500 VIX Short-Term Futures Index, less fees. The product sees exceptional volume of nearly eight million shares a day and has AUM of close to $370 million. The ETN does charge a rather high expense ratio of nearly 1.65% a year though, among the highest in the space.
The note has been under a firestorm of controversy as of late, thanks in part to the massive premium that has developed in the product. In mid-February, the issuer of the shares, Credit Suisse, announced that it would be suspending new shares of the note as it worked to develop better risk management techniques for the ETN (read Understanding Leveraged ETFs).
This decision caused the note to deviate significantly from its underlying value, creating an enormous premium in TVIX. In fact, at one point, the premium was nearly 100%, meaning that the ETN was trading for more than two times what its assets were actually worth.
In this short time period, TVIX was able to outperform other ETNs in the space, as the premium helped to keep the product afloat despite declining volatility. However, just recently, Credit Suisse announced that it would be resuming creations on a ‘limited basis’ forcing the premium to plummet to its current level below 4%.
Thanks to this dissolving premium and the general weak performance in the volatility market, TVIX has declined by nearly 56% in just the past month alone. This suggests that it has been an extremely rough period to be a volatility investor and that the premium was the only thing saving the fund from bigger losses in early March, although this was obviously not going to last (also see Use VIX ETPs To Profit From Market Volatility).
iPath Dow Jones-UBS Natural Gas ETN (NYSEARCA:GAZ)
This note looks to give investors performance that is identical to the Dow Jones-UBS Natural Gas Total Return Sub-Index. This represents a benchmark of the commodity of natural gas, a critical fuel for heating and cooling across the United States. The product currently has solid volume of about 400,000 shares a day although it has just $60 million in AUM.
This note has been one of the most egregious examples of an ETN premium on the market, although it is still a pretty new case. The note was trading pretty much in-line with its NAV until the end of January when the massive premium first began to develop (read Have The Natural Gas ETFs Finally Bottomed Out?).
It is also interesting that it took so long for the premium to happen in the first place. After all, Barclays had suspended new creations in GAZ in August of 2009 and an enormous deviation from fair value didn’t develop at all in 2010 or 2011. Possibly, the immense changes in the natural gas market over the past few months gave this ETN a kick towards higher premiums unlike what investors saw previously.
Once this happened, the premium really took off, soaring to unprecedented levels. In fact, at one point the premium reached nearly 134%, among the highest investors have ever seen in the space.
This massive total has begun to recede in recent weeks as now the premium is ‘only’ 64%. This trend to a slightly lower premium, coupled with weak natural gas prices, drove GAZ to a nearly 30% loss in the last full week of March. However, when looking from a longer term perspective, the premium buildup may have temporarily helped investors in the fund as the ETN is down just half a percent so far this year compared to a nearly 38% loss for the product’s NAV.
Generally speaking, when a premium collapses, this can cause the share price to fall even if the underlying is rising. Thanks to this, some investors are likely to protest the result, an issue that could result in more backlash for the ETP industry or lead to more lawsuits by dismayed investors.
How To Avoid
Luckily for investors, there are several ways to avoid this problem. First and by far the easiest, is for investors to keep an eye on highly illiquid funds or those that employ less traditional strategies such as investing in volatility or commodities (see Three Commodity ETFs That Have Not Surged).
Beyond this, investors also have a few options to each of the ETNs highlighted above. These products—which are all ETFs—are not experiencing the same premium issues and thus could be better choices for investors who are worried about a collapsing premium hurting an otherwise solid investment decision:
ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY)
This ETF also looks to give investors daily 200% performance of the S&P 500 VIX Short-Term Futures Index. However, instead of just promising to match an index, the ETF uses CBOE Volatility Index Futures to accomplish the task.
This strategy has proved to be increasingly popular with investors—especially in light of TVIX’s woes—as the ETF has amassed nearly $133 million so far. The ETF also sees solid volume of close to 700,000 shares a day and is actually trading at a discount of about 1%.
Thanks to this, the ETF has been much better about trading in-line with its NAV, although this has hardly helped from a performance standpoint. In fact, UVXY has lost about 54% over the past month although its performance has been more due to volatility than premium and discount issues like we have seen in TVIX.
United States Natural Gas Fund (NYSEARCA:UNG)
Easily the most liquid ETF in the natural gas space is USCF’s UNG. The product looks to track the changes in percentage terms of the price of natural gas futures contracts that are traded on the NYMEX. The ETF is extremely popular trading over five million shares a day while possessing more than $800 million in AUM.
This ETF has done a much better job of staying in-line with its NAV and is currently trading at a discount of just about half a percent. This is trend stretches back quite some time and shows that just because Credit Suisse suspended creations in its natural gas product it doesn’t mean all other issuers have to do the same (also read Forget UNG: Try These Natural Gas ETFs Instead).
Meanwhile, the product’s more spread out counterpart, (NYSEARCA:UNL), also trades roughly in line with the NAV as its discount is just 0.3%, offering up investors another option to avoid the premium issues that are inherent in GAZ.
Nevertheless, much like in the case of the volatility ETPs, the product with the premium has outperformed on a longer time frame, losing just 6.3% in the past three months compared to a 36.7% loss for UNG in the same period. However, over the last week in March, the trend has reversed with dangerous implications; UNG has lost 9.1% in this period while GAZ collapsed by nearly 28.5% in the same time.
Clearly, investors need to be on the lookout for significant premiums which can develop in ETNs during unusual circumstances. These premiums can drive returns in a way that can take over gains and losses, making fundamentals meaningless in comparison. Additionally it is important to remember that when the premium is trending in your favor, it can be a boon to returns yet when it is declining it can multiply losses significantly.
Lastly, investors will probably hear about how ETNs are somehow ‘flawed’ products over the next few weeks, given the troubles in TVIX and GAZ. Just remember that ETNs are not usually prone to this trend and that this significant premium can only develop when the arbitrage mechanism breaks down and ETFs and ETNs begin to trade more like closed-end funds than other exchange-traded products. Unless this happens, ETNs are pretty secure investments and we should rest assured that, except in extreme circumstances, they will follow through on their intended goals.
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