Leveraged & Inverse ETN Extinction

In the ETF industry, an extinction is quietly taking place.

So far this year, 173 exchange-traded products have shut down, delisted, been closed to creations or otherwise become unavailable to investors.

That in itself is a remarkable number—last year, only 126 ETFs shut down—but the sheer volume of closures conceals something else remarkable: 50 ETNs have shut up shop so far in 2020, and almost all of them are leveraged or inverse.

So far this year, 38 leveraged and/or inverse ETNs have been called, redeemed, closed to creations or expired, or their imminent closure has been announced. That's three-fourths of all ETN closures, and one-fifth of all exchange-traded products so far to close in 2020, period.

Source: FactSet; data as of July 7, 2020

In contrast, only 15 leveraged and/or inverse ETFs have shut down this year, out of a total 123 ETFs to kick the bucket.

What makes leveraged/inverse ETNs so uniquely exposed to closure risk? And what does 2020's bloodbath bode for the 55 leveraged/inverse ETNs still on the market?

Proportionally More Leveraged ETNs Than ETFs
The answer to the first question is: It's complicated.

First, there's something of a selection effect at work here: Leveraged/inverse ETNs are more likely to shut down simply because ETNs are more likely to offer leveraged and inverse exposure. Roughly 45% of ETNs offer some kind of leveraged/inverse exposure—compared to just 8% of ETFs.

That's because leveraged and inverse exposure is often easier to achieve in the ETN vehicle—which is just a debt instrument whose return is tied to the return of a given index—than in an ETF.

An ETN holds no securities; any return it offers, leveraged or not, is simply an index calculation. An ETF, however, must own physical securities, meaning the portfolio manager must dip into the derivatives market to achieve leveraged and inverse exposure.

Why 2020 Has Been Hard For Leverage
In addition, we've seen persistently high market volatility this year. That's good for bargain-hunters but challenging for leveraged and inverse products, whose massive price swings under such conditions don't always match investors' expectations.

As a reminder, leveraged and inverse funds offer exposure not to some multiplier of the total return of their underlying indexes, but rather to a multiplier of the daily return of their underlying indexes. (Read: "Don't Buy & Hold Leveraged ETFs.")

As a result, any disparities between benchmark and ETP price can and often do quickly compound in highly volatile markets, where prices whipsaw up and down over the course of days. (Of course, leveraged and inverse funds can go haywire even in sideways, low volatility markets, too.)

Most leveraged/inverse ETNs have fail-safe clauses in their prospectuses to prevent their share prices from going negative. If the price of that note falls too quickly, or passes some minimum price threshold, then the ETF automatically “accelerates” (meaning, its redemption date is moved up and the note shuts down).

Due to 2020's high market volatility, many leveraged/inverse ETNs hit those thresholds and were mandatorily redeemed. Still others came too close for the issuers' comfort and were shut down before they could get the chance to trigger the fail-safes.

As a result, many ETNs closed that weren't intended to be redeemed for another two decades or more. (Read: "Leveraged ETF Closures Piling Up.")

Delisting: Still The Worst Possible Outcome
As surprising as a mandatory redemption can be, it's actually a form of investor protection; investors can rest assured that they will receive some—though by no means all—of their investment back on the redemption date.

That's not the case for delisted ETNs. Delisting usually occurs when an ETN falls below the minimum indicative value required by an exchange—which has happened to several leveraged and inverse products this year, particularly in those with energy and bearish precious metals exposure, for obvious reasons.

When a product is delisted, it is taken off its exchange; no more trades may be executed in it, except in over-the-counter (OTC) markets.

The ETN doesn't close, however. Instead, investors who do not exit the note before its delisting date are stuck with positions that are extremely difficult and expensive to liquidate, especially for retail investors lacking easy access to OTC trading.

Several leveraged/inverse ETNs have delisted so far in 2020, including the iPath US Treasury Long Bond Bear ETN (DLBS) and the iPath US Treasury 10-Year Bear ETN (DTYS), whose indicative values had fallen below their exchange's minimum required share price.

That said, an issuer may decide to delist its products on its own discretion or on the discretion of the bank backing the note—as was the case for VelocityShares, which recently announced the delisting of several leveraged and inverse ETNs.

The most high profile of these was the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), which had $1.4 billion in assets under management as of the time of the announcement. (Read: "Popular ETNs Delisting In July.")

An issuer choosing to delist its own notes instead of redeeming them for investors is highly unusual, however, and very rare.

What Happens Next?
There are 122 ETNs left on the market, 55 of which (or 45%) are leveraged and inverse—many of them offering the same industry or sector coverage as the products that shuttered earlier this year. What will become of them?

Unfortunately, their days may be numbered. And that's not necessarily because the ETN structure is losing popularity, but because leveraged products are less popular than ever.

The percentage of the total ETF market that leveraged ETPs represent has steadily declined over the past 10 years, falling from 1.3% of total ETP assets in 2010 to just 0.68% in 2020.

Same for inverse products, which fell from a 2.1% market share 10 years ago to just 0.51% invested today. (Read: "Leveraged & Inverse ETF 'Mirage.'")

That's likely because institutional hedgers and active ETF traders—the main user base for leveraged/inverse products—have become a smaller portion of the ETF market. The slack has been taken up by retail investors, who, despite all the ink spilled about Robinhood traders, are by and large staying away from leveraged/inverse products.

Leveraged and inverse ETNs are niche products, and they're only getting niche-ier—if they even survive 2020 at all.

Contact Lara Crigger at [email protected]