It’s Time For An ETF Gate

March 29, 2012

With headlines still screaming about TVIX, maybe it’s time regulators start thinking seriously about gated access and ETF reform.

Normally I consider it a good thing when my phone rings off the hook with reporters asking smart ETF-related questions.

But the last two weeks have been a bit more of a grind than usual. Enough that I think perhaps it’s time for Washington to get serious.

The phone calls have come in a few flavors, all driven by the VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX).

As we’ve covered here extensively over the past month, TVIX experienced an enormous premium spike after Credit Suisse—the ETN’s issuer—halted creations, and then experienced a subsequent premium collapse just before Credit Suisse announced a limited restart of creations.

What’s so interesting to me here is what it takes to get people riled up.

To me, the rise and fall of TVIX was entirely unsurprising. After all, once creations are halted in any exchange-traded product, they effectively become closed-end funds. Since the redemptions aren’t generally halted, the pressure is purely for the fund to trade at a premium.

That premium on TVIX, however, was kind of insane, because anyone who wanted the underlying exposure could just as easily have an ETF version of the same product from ProShares (NYSEArca: UVXY). In fact, if you were holding TVIX when the premium appeared, you could have simply sold it and bought UVXY and immediately pocketed the difference.

My assumption is always that those folks buying in a spike like this are serious Wall Street players who are gaming a momentum chart and hunting for greater fools.

But then, there’s this morning’s Wall St. Journal article, which features the sad story of a man named Eric Brehm, who bought TVIX as a hedge against his portfolio on Feb. 22—the day Credit Suisse halted creations. The Journal has used Eric as a poster child for what happened in TVIX, but the problem here isn’t one of TVIX—it’s one of poor judgment.

Eric bought TVIX as a “hedge” against a market downturn. Since Feb. 22, the S&P 500 is up almost 4 percent. The VIX itself is down 14.95 percent, and even the most naive-guess on what -2X VIX means should be puts him down 30 percent.

Of course, you can’t buy VIX, so TVIX—and every other volatility product—tracks VIX futures. Because it’s a leveraged product, it has to rebalance daily—as the name of the product suggests.

The impact of that daily rebalancing, plus the substantial contango in VIX futures would suggest Eric “should” have lost 56.71 percent. That’s how much the index TVIX is tracking is down, once you include TVIX fees. That’s the NAV loss. How much did Eric lose? Well, the actual market value of TVIX is down 57.41 percent.

These NAV and price-return figures are almost identical to the equivalent ProShares product, UVXY, which is structured as a commodities pool.

Of course, in between when Eric bought it and today, he saw the price shoot up, in no relation to the underlying value of his investment. So perhaps he thought he was a genius for betting on TVIX, and is lamenting his paper losses. But the bottom line is that his bet on 2X volatility futures was a terrible idea.


The structure didn’t fail Eric here. Eric failed Eric.

You see, I’m going to guess that Eric never read the pricing supplement for TVIX. I’m going to go so far as to say he probably didn’t understand that with VIX futures in crazy contango throughout the last month, his expected return was quite negative.

But the solution isn’t to ban ETNs, as the most hyperbolic CNBC commentators would suggest.

The solution is also not labeling—where only certain structures could call themselves “ETFs”—as BlackRock would suggest.

The solution is gating.


If Eric wanted to open a futures account and trade VIX futures, he’d need to clear an hour off his schedule.

He’d have to read and sign a piece of paper saying he’d read and understood a rather lengthy set of risk disclosures from the Commodity Futures Trading Commission. So why should he be able to invest through a backdoor in those exact same futures through TVIX or another volatility product like the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca: VXX)?

He shouldn’t be.

If Eric wanted to make a huge leverage bet on the S&P 500, he’d have to open a margin account, which comes with another pile of paperwork explaining the risks and limits of leverage. Why should he be able to make the exact same leveraged bet through a backdoor?

He shouldn’t be.

Instead, ETFs should go through a review process that actually categorizes them based on their risks, exposures and complexity. Products that cross certain lines—leverage, derivatives use, path-dependent fees—should be put behind a separate set of disclosures.

To be clear, I’m not crying foul on plain-vanilla ’40 Act funds like the Vanguard Total Bond Market ETF (NYSEArca: BND) or the SPDR S&P 500 ETF (NYSEArca: SPY), because disclosure on relatively straightforward funds is perfectly adequate.

But there should be disclosure on more complicated securities, whether they’re structured as:

  • '40 Act funds like the ProShares Ultrashort S&P 500 ETF (NYSEArca: SDS)
  • commodities pools like UVXY or the United States Oil Fund (NYSEArca: USO)
  • or as ETNs, like TVIX


These disclosures could either be implemented as interstitials to trading—pop-up screens, required live-broker scripts—which would be tremendously unpopular.

Or they could simply be implemented at the account level, like access to shorting or access to options or access to margin.

Frankly, I think they could be implemented with a fairly simple set of rules from the Financial Industry Regulatory Authority. Again, FINRA members—the brokerage firms—would hate it, but I think it would work.





But then there are ETNs. I’m actually a fan of ETNs in general: Perfect tracking and fantastic tax treatment in exchange for a little counterparty risk is a trade I’m willing to make. The problem is that ETNs live in an extremely gray area of the market.

There are two unique things about ETNs that mean they should be behind the gate, regardless of whether the pattern of returns promised is something as simple as the S&P 500 or as complex as TVIX.

The first is counterparty risk. ETNs, because they’re debt, could technically be defaulted and become worthless. This means they should trade at a slight discount to compensate for that risk. But they don’t.

Interestingly, some academic finance wonks are in the process of figuring out that little mystery. It’s not an enormous risk—the only people to ever lose their ETN shares in bankruptcy were the last-ditch holders of the Lehman Opta ETNs, and even they got pennies on the dollar eventually.

The second—and this is much more important—is informational risk. By that I mean the risk that you’re not actually buying what you think you’re buying. I’d argue that this is present in mutual funds, insurance products and plain-vanilla ETFs as well.

But in ETNs, it can be exceedingly difficult to actually figure out what you should rationally be expecting. ETN pricing supplements look nothing like a traditional fund prospectus, and the words used to describe fees and expenses are entirely alien to a die-hard fund investor.

To make matters worse, because most ETNs are issued under blanket registrations, there’s very little actual Securities and Exchange Commission oversight on what’s promised in the ETN documentation.

Yes, there are basic requirements that have to be met for any bond issuance, but there isn’t any boundary on what pattern of returns can be promised.

There are no limits on “derivative exposure” or shorting or anything else, because the ETN simply doesn’t hold anything. You could quite literally launch an ETN indexed to my age that would reset to zero on my death, creating a virtual chicken version of a “Dave Nadig Death Pool.”

This leads to all sorts of interesting quirks, like the path-dependant pricing of many ETNs recently highlighted by Morningstar, or the “Event Risk Weekly Hedge Cost” for the short Volatility ETNs from UBS—a surprise 4 percent annualized fee to someone who isn’t paying attention.

Unless the SEC radically alters the structure under which ETNs are reviewed, which seems exceedingly unlikely, that means ETNs as a class probably need to be behind the gate too.

Lower The Gate

I’d like to think people actually learn about their investment vehicles before they purchase them.

But I’m not that naive. ETNs like TVIX or ETFs like UVXY or the United States Natural Gas Fund (NYSEArca: UNG) do indeed have special risks.

These are special risks you can only find out about by doing some serious proactive digging.

It’s not that the products don’t work. It’s that the distribution system doesn’t.


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