ETFs and ETNs

An exchange-traded note ETN is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer. ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Thus ETN has an additional risk compared to an ETF, if the underwriting bank goes bankrupt, the investment might lose value in the same way as a senior debt would. Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted. Similar to index funds, they are linked to the return of a benchmark index. But as debt securities, ETNs don't actually own anything they are tracking.

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. ETFs are the most popular type of exchange-traded product.

Only so called authorized participants (typically, large institutional investors) actually buy or sell shares of an ETF directly from or to the fund manager, and then only in creation units, which are large blocks of tens of thousands of ETF shares, usually exchanged in-kind with baskets of the underlying securities. Authorized participants may wish to invest in the ETF shares for the long-term, but usually act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates to the net asset value of the underlying assets.[4] Other investors, such as individuals using a retail broker, trade ETF shares on this secondary market.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs.

Many investors suffered losses in the ETN TVIX earlier this year and have expressed outrage. The Credit Suisse VelocityShares 2x VIX Short Term Futures fund lost almost 60 percent of its value in just one week. The TVIX is a misunderstood product, and the action of the last week hasn’t helped VIX-based funds. Some investors also expressed outrage that the Securities & Exchange Commission approved such a fund in the first place, especially given this disclosure in the prospectus, which is bold-faced and underlined: “The long term expected value of your ETNs is zero. If your ETNs are a long-term investment, it is likely that you will lose all or a substantial portion of your investment.” The same would also apply to UVXY, and over a longer period of time VXX.

Getting long volatility used to be done by buying options. Various exchange-traded products linked to the VIX give traders exposure to volatility without having to buy options and delta hedge. But option traders know that options that are out of the money have an expected long-term value of zero. However most traders have not signed up to futures and options trading with their online brokers.

When Credit Suisse stopped creating new shares of the TVIX. It soon began trading for more than its net asset value, similar to a closed-end fund. That premium climbed as high as 89 percent immediately before it crashed. But that selloff only brought it back to its real value based on assets. So, over the space of a month, its performance was similar to that of the similar ProShares Ultra VIX Short Term Futures Fund UVXY. Only those people who bought TVIX far above its real value got hurt when the premium got sucked out. Buying a security you don’t understand, for almost twice what it's worth, is a good way to lose money.

Yes, this was all disclosed in documents. No one should buy a product without knowing the risks. Most people that lost very likely did not understand what they were doing, and they should not have been messing with a fund at huge premiums to net asset value, but this debacle still doesn't give much confidence that we're playing in a fair marketplace. My view is that introducing this kind of toxic product to the mostly unsuspecting market place is almost as bad as bringing a new car to market that has not been fitted with brakes. Where were the SEC in all this?