Nick Cherney was still on the slopes when he realized something was wrong. The outdoor enthusiast, who runs exchange-traded products at Janus Henderson Investors, was just skiing back into Aspen after spending eight hours on some of Colorado’s toughest backcountry terrain. He’d been without a cell signal all day and, as he looked at his phone, he started to fear this was no ordinary Monday.
Almost 2,000 miles away in New York, traders were in an uproar. It was Feb. 5, 2018, and stocks had tumbled more in a single day than they had in six and a half years. The Cboe Volatility Index, or VIX, had spiked 116 percent—its biggest jump ever.
Amid the tumult, Cherney focused on two ETPs. Both were getting smoked in after-hours trading as their bets against market volatility crashed. The day’s move had wiped out 90 percent of the $3 billion-plus that institutions and retail buyers held in the two ETPs the previous week.
One was painfully familiar to the then-37-year-old Cherney, who’d helped structure the VelocityShares Daily Inverse VIX Short-Term ETN for VelocityShares before Janus acquired the company. “I pulled up to look at the markets, and I was like, that can’t be right,” he says.
Soaring volatility had sent both short-VIX ETPs plunging as Cherney had trained for a grueling 40-mile race through the Elk Mountains. But the fates of the two ETPs were starkly different: One would be shuttered, while the other survives to this day.
Why the difference? Cherney’s product was an exchange-traded note, an unsecured debt obligation of the bank that created it. It could be terminated at any time. The surviving product is, by contrast, a type of fund. The differing outcomes came as a surprise to many in the $3.6 trillion U.S. market for ETPs, inviting greater scrutiny of this wonky corner of the industry. The U.S. Securities and Exchange Commission is now considering a plan to more clearly differentiate between types of ETPs.
For his part, Cherney says investors’ surprise about the VelocityShares ETN wasn’t warranted. “Unfortunately, there are a lot of people who aren’t as financially savvy as they could be,” he says. “ETNs set out how they work in their prospectus. It’s up to investors to go out and read that.”
ETNs had a promising start. When accessing stocks in countries such as India was all but impossible, these notes offered a way in. They helped in the same way with commodities and currencies—assets that had been unavailable to investors without a large bank or trading shop to help them.
First used by Barclays Plc to describe two broad commodity products in 2006, the exchange-traded note quickly caught on. Some ETNs used derivatives to enable investors to bet against securities or markets or to juice returns. Deutsche Bank, UBS, Goldman Sachs, Lehman Brothers, and other banks joined the fray, augmenting their structured-products businesses.
Lehman’s bankruptcy focused investor attention on the risks of unsecured bank debt, while the rise of exchange-traded funds offered an alternative. Notes now account for only about 0.6 percent of assets in the ETP market, down from a peak of 1.4 percent in 2010, data compiled by Bloomberg show. Still, as the overall market has grown, ETNs house more assets than ever and remain among the most-traded ETPs.
“There are a few pockets where ETNs can provide value that exceeds an ETF,” says Greg King, chief executive officer of REX Shares LLC, which has run both types of product. “But it’s in 5 or 10 percent of exposures,” he says. King worked on Barclays’s first ETNs and co-founded VelocityShares with Cherney.
The genes the notes share with their fund cousins help the 190-odd ETNs trade on U.S. exchanges almost incognito alongside more than 2,000 ETFs. Cherney’s ETN—issued by Credit Suisse Group AG and known as XIV—was so beloved by ordinary investors that it had its own thread on the discussion board Reddit.
Even in good times, though, ETNs can hurt the unsuspecting. Take one that promises three times the daily return of a gas or oil index. Hold it one day, and you’ll get close to triple the daily performance of that gauge. But keep it longer, and your performance will diverge as the strategy resets each day. The bigger the move, the greater the gap. While not unique to ETNs, these risks—along with the cost of rolling futures contracts—are prevalent. Regulators won’t allow any new companies to sell leveraged ETFs, leaving just two issuers of juiced-up funds and a bunch of geared ETNs. This is one reason the offering documents say they’re intended for sophisticated investors.
But even professionals can get snared. Despite multiple warnings from Barclays, more than $550 million of investors’ money remains in 32 notes that it delisted in April, making the notes far harder to sell. Some issuers can redeem or accelerate their notes at will, or even unexpectedly stop supplying them. JPMorgan Chase & Co. hasn’t sold new securities for a $3 billion ETN it runs—the U.S.’s biggest—since 2012, risking price dislocations.
ETNs even pose a risk to the banks that issue them. Barclays replaced 15 commodity ETNs this year because the old versions lacked a now-standard option to call the securities. Regulators are demanding banks set aside more capital to offset liabilities, including ETNs. And the reputational damage suffered by Credit Suisse over XIV has given banks pause.
Put simply, ETNs may be more trouble that they’re worth.
“ETNs wormed their way into the ETF industry, as they offered exposure to things that you couldn’t get in an ETF, but in retrospect it probably was a bad idea,” says Eric Balchunas, a senior analyst at Bloomberg Intelligence. “I wouldn’t be surprised if they slowly get weeded out of existence.”
Deutsche Bank and Goldman Sachs—both early ETN adopters—have refocused on ETFs, and UBS Group AG, which still manages a bunch of notes, started two ETFs last year. REX’s King has marketed a blockchain fund, alongside ETNs. Cherney now sells ETFs for Janus, as well as notes.
Fisher Investments, which manages $93 billion from Camas, Wash., is the single largest user of ETNs, accounting for about $10 billion of the $28 billion in U.S. products, regulatory filings show. It works with multiple banks to create bespoke leveraged strategies that reset once a quarter, something not possible within an ETF. A spokesperson for Fisher declined to comment. ETNs can also have a narrower focus than ETFs and are generally taxed more favorably—particularly for some energy companies.
Despite regulatory grumblings about better labeling in the wake of XIV’s demise, notes lie next to funds in brokerage accounts across the country. “The existing products are robust, they trade a lot and are pretty well-loved by the people that use them,” Cherney says. “I don’t think ETNs are going anywhere.”
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