Michael Gamble, a 67-year-old retiree, doubled down on a volatility exchange-traded note backed by Credit Suisse Group AG (CSGN) last week as it declined to a record low price.
“When it started to fall, I bought more because I couldn’t believe how low it was going,” he said in a telephone interview. “I didn’t realize I was playing with a hand grenade.”
Gamble, who lives in Frisco, Texas, didn’t know the product was trading at a premium to its targeted value, a rare event for ETNs, or that institutional investors were selling the notes short on a bet they would fall. The note tumbled by more than 50 percent on March 22 and March 23, costing Gamble about $20,000.
The crash calls attention to the way many ETNs, which are more complex and risky than exchange-traded funds, open the door to markets where individual investors normally can’t venture without brokerage approval. It also may sour small investors on exchange-traded products, an industry that has grown to almost $1.2 trillion in U.S. assets because of the popularity of low- cost ETFs.
“ETPs are one of the great success stories of marketing by creating a new name and new brand,” said Mercer Bullard, an associate professor of law at the University of Mississippi and founder of the advocacy group Fund Democracy Inc. “Now the non- fund ETPs are undermining the ETF brand.”
Credit Suisse stopped issuing new notes on Feb. 21 after the market value more than quadrupled from the end of 2011, unhinging the share price from the index it tracked, the S&P 500 VIX Short-Term Futures Index. The price quickly developed a premium over the notes’ targeted value that peaked at 89 percent on March 21.
Hours before the bank said it would resume issuing new shares, the ETN’s price began falling on March 22 even as the index was rising. By the end of March 23, the premium had collapsed to 6.9 percent as the notes tumbled.
The U.S. Securities and Exchange Commission is reviewing the price gyrations involving the Credit Suisse VelocityShares Daily 2x VIX Short-Term ETN (TVIX:US), a person familiar with the matter said yesterday. John Nester, a spokesman for the SEC in Washington, declined to comment. Credit Suisse is cooperating with regulatory authorities, said Katherine Herring, a spokeswoman for the Zurich-based bank.
The investigation comes as the SEC is beefing up its ability to regulate exchange-traded products. Agency investigators will hold an intensive training session on ETFs next week, Bruce Karpati, co-head of the asset-management unit of the SEC’s enforcement division, said at a securities law event today in New York.
The SEC also hired Barry Pershkow, former counsel at ETF provider Proshares Advisors LLC, in January to advise the staff on ETF-related matters.
ETNs, with about $17.3 billion, have benefited from an association with ETFs, a product that offers a different set of promises. While some ETFs also offer access to markets that are impossible for most retail investors to reach directly, they are more tightly regulated.
“It’s likely that anything called ‘exchange-traded’ will be viewed as operating under the same set of rules,” Bullard said. “If they’re not, we have a regulatory problem.”
The Credit Suisse note, which trades under the ticker symbol TVIX, is an unsecured debt instrument designed to provide about twice the daily return of an index that gauges expectations for volatility in U.S. stocks. It is one of at least 25 U.S. ETNs linked in some way to stock market volatility, according to data compiled by Bloomberg.
Had Gamble sought to invest in options on volatility futures himself, he would have faced hurdles, said Brian Lenart, chief executive officer of BDL Compliance Consulting and former head of compliance at Marsh & McLennan Securities. He’d have been required to fill out an options agreement and be approved by a registered options principal, a brokerage employee with a Series 4 securities license.
The complexity of the strategies an investor is able to employ is up to the discretion of the options principal, generally the firm’s head of compliance. Granting permission for more complex strategies tends to be difficult, Lenart said.
“I try to imagine, ‘How is this going to sound in a hearing?’” Lenart said in a telephone interview from his Chicago office. “If an investor comes in and has a blown-up option-futures strategy, almost any panel is going to rule for that customer.”
With TVIX available via a mouse click at an online brokerage, Gamble faced none of those obstacles.
“I guess there’s a little bit of blame on both sides,” Gamble said. “But if something is trading that way, there should be a way to tell people about it.”
David Nadig, director of research at San Francisco-based ETF research firm Index Universe LLC, said his company advocates “gates in front of exchange-traded products that mirror the rules regarding access to the underlying markets.”
“That could have solved the majority of problems if TVIX investors had to sign all the disclosures necessary for investing in volatility futures,” Nadig said in a telephone interview.
“This thing is going to create a reputational hazard for issuers of ETNs,” he said, referring to the price gyrations. He said he didn’t think problems in the ETN field would hurt providers of traditional ETFs.
Brokers are required to make sure a product is suitable for customers. The Financial Industry Regulatory Authority, the brokerage industry’s self-regulator, issued a notice in January warning brokers about complex products, including those linked to stock market volatility.
“We have been closely looking at the events and trading around TVIX,” George Smaragdis, a spokesman for Washington- based Finra, said in an e-mailed statement.
Self-directed investors like Gamble won’t get the benefit of a broker’s warnings.
“Working with a discount firm with no broker is the risk customers take,” Mark Astarita, a founder of law firm Beam & Astarita LLC in New York, said in a telephone interview. “They’re on their own.”
Astarita is a securities attorney who represents brokerage firms in arbitration proceedings conducted by Finra.
Restricting eligibility to the most complicated products may save some investors from missteps, and annoy others.
Exchange-traded products have grown popular, in part, for giving individuals easy, cheap access to areas of the market once restricted to institutions.
ETNs, while comparatively small, can attract significant interest from investors. The iPath S&P 500 VIX Short-Term Futures ETN (VXX:US) was among the 10 fastest growing exchange-traded products in the world in the first two months of 2012, gathering $1.1 billion in new assets, according to New York-based BlackRock Inc., the industry’s largest provider. The largest ETN is the JPMorgan Alerian MLP Index ETN at $4 billion.
For investors in the Credit Suisse ETN who didn’t pay enough attention, the freedom to access a complex market backfired after the Zurich bank ran into size limits on the derivative positions it took to ensure it could match TVIX’s targeted return.
Natural Gas Note
Issuers typically stop adding shares when they reach a limit on their derivative positions that is either imposed internally or by an exchange or regulator, according to Samuel Lee, an analyst at Chicago-based Morningstar Inc.
The price of the iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN (GAZ:US), a note issued by London-based Barclays Plc, followed a similar trajectory over the past eight weeks, rising to a premium as high as 134 percent over its indicative value before falling to a premium of 56 percent over six trading days.
ETFs also have whipsawed investors. The Market Vectors Egypt Index ETF traded at a premium as high as 28 percent in March 2011 when the Cairo Stock Exchange was forced to close during the country’s uprising. The shutdown prevented the fund from buying or selling its underlying stocks.
U.S. Natural Gas Fund (UNG:US), another ETF, suspended the creation of new shares in August 2009 when it reached limits set by the Commodity Futures Trading Commission on futures positions. Its premium reached 19 percent.
Exchange-traded funds, which first appeared in 1989, offer investors a convenient way to invest in all or part of a market by tracking an index. Unlike index mutual funds, they trade on an exchange throughout the day, like stocks.
ETNs, introduced by Barclays in 2006, can offer advantages over ETFs, including lower taxes. They also lack protections built in to ETFs.
In the U.S., ETFs are governed by the Investment Company Act of 1940 that also covers mutual funds. They are stand-alone companies that own the underlying securities, and they elect fund boards whose members are legally bound to look after the interests of shareholders.
ETNs, by contrast, are unsecured debt securities registered under the Securities Act of 1933 and typically issued by a bank. The issuer promises to redeem the notes at the value of the index investors seek to track. If the issuer goes bankrupt, ETN investors are put in line with other creditors and may lose all or part of their money.
‘Embraced by Retail’
The 1940 Act also standardizes prospectus disclosures, making total costs easier to see, Nadig said. ETN issuers can write pricing supplements to the documents “in any way they like,” which can make expected returns difficult to calculate, he said.
“These products weren’t necessarily intended for retail,” said Rudy Aguilera, chief investment officer at Orlando, Florida-based Ironclad Investments LLC, “but were certainly embraced by retail.”
Senator Jack Reed, a Democrat of Rhode Island, said yesterday he was monitoring the issue surrounding ETNs. Reed held a hearing in October that examined whether exchange-traded products posed risks to financial markets and investors.
“I think this market deserves more attention from both domestic and foreign regulators and I plan to hold another hearing on ETFs and related issues in the near future,” Reed said in an e-mailed statement.
Massachusetts’ chief securities regulator is also conducting an investigation into the Credit Suisse ETN.
In a letter to the bank on March 23, William F. Galvin, secretary of the commonwealth, demanded information about investors and the firm’s decision to resume issuing shares. The price of the ETN began falling hours before Credit Suisse announced that decision.
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