Don't Touch This ETN: It's Exchange-Traded Nitroglycerin

At the end of last month, I warned that surging trading volumes in the iPath VIX Short-Term Futures ETN (NYSE: VXX  ) and the VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX  ) could have ominous implications for investors. Less than a month later, investors holding the latter product suffered a bloodletting, losing 50% over a two-day period, during which the VIX Index (INDEX: ^VIX  ) lost just 2%. If you weren't a party to it, count yourself lucky, but take heed of the lessons of this miserable episode -- it won't be the last of its kind.

The painful end of a relationship
But Alex, I hear you say, TVIX doesn't promise it will deliver twice the performance of the VIX Index as such. In fact, VelocityShares' documentation states explicitly that "the ETNs are not linked to the VIX Index." Fair enough, but the TVIX is supposed to replicate twice the daily performance of the S&P 500 VIX Short-Term Futures Index ER, before investor fees. Let's see how the TVIX held up by that standard:

 

March 22

March 23

S&P 500 VIX Short-Term Futures Index ER 1.4% (7.3%)
VelocityShares Daily 2x VIX Short-Term ETN Expected*
2 * 1.4% = 2.8%
Expected*
2 * (7.3%) = (14.5%)
VelocityShares Daily 2x VIX Short-Term ETN Actual
(29.3%)
Actual
(29.8%)

*Before investor fees. Source: Author's calculations based on data from Bloomberg and Yahoo! Finance.

Houston, we have a problem! Incidentally, TVIX lost another 17.8% yesterday, although that does happen to match its objective, since the underlying index lost 8.5%. In the space of three trading days, the TVIX has suffered a stunning cumulative loss in excess of 60%! No wonder documentation on the TVIX warns:

The ETNs [exchange-traded notes] may not be suitable for investors who plan to hold them for longer than one day. The long-term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment.

Fair warning, I suppose. In the era of high-frequency trading, maybe three days qualifies as a "long-term investment.")

Precious and risky
Incidentally, investors in precious-metal exchange-traded products (ETPs) also face complex risks. With the rise in popularity of these products, there is increasingly a "dog wagging the tail" phenomenon, even among products such as the iShares Silver Trust (NYSE: SLV  ) and the SPDR Gold Shares (NYSE: GLD  ) that own the physical metal instead of futures contracts. A forthcoming article in the Journal of Derivatives and Hedge Funds concluded:

The empirical findings of this study suggest that there is a strong statistical significant positive contemporaneous relationship between the inflows and outflows in the precious metals ETPs and the returns of the underlying metals. This interdependence raises the risk of potential severe redemption pressures on certain types of ETPs in cases of market turmoil, which could in turn hurt the large asset managers and banks active in this market.

English language translation: The activity in precious-metal ETPs and ETFs is affecting the spot metal prices (i.e., prices in the physical market). That impact raises the risk that anyone who has exposure to these products will suffer in a period of market stress.

Are ETNs right for you?
Should you own futures-based ETPs? Here is a seven-question checklist I've put together:

  • Do you use volatility/commodity ETPs primarily for speculation?
  • Are you a professional investor?
  • Do you manage your portfolio like a professional investor? (Just looking at your portfolio value on a daily basis doesn't qualify as a "yes.")
  • Do you understand the structure of ETNs?
  • Are you familiar with all of the following terms and the underlying concepts: cash-and-carry arbitrage, contango, backwardation, and roll yield?
  • Have you read and fully understood the "Risk Factors" section of the prospectus for all of the ETPs you own?
  • Did you understand the earlier quote from the article on precious metals without needing to read my translation?

If you answered "no" to any of these, you need to make an honest assessment of whether you have the knowledge and experience to trade these products. If you answered "no" to three or more, I'd suggest you seriously consider giving up using them altogether. If you do decide to continue, keep in mind VelocityShares' warning: "You should proceed with extreme caution in considering an investment in the ETNs."

Avoid this fetish
Unfortunately, I don't think the individual investors who trade these products will read (or heed) this warning. The result will inevitably be the one that institutional brokerage Oscar Gruss & Co. CEO Michael Shaoul predicted in Barron's Online yesterday: "The fetish of volatility trading will eventually be discredited, but not before it has caused a great deal of angst in the investing public."

Why do investors always want to look for "complicated returns" when The Stocks Only the Smartest Investors Are Buying are right before their eyes?

Fool contributor Alex Dumortier holds no position in any company mentioned. You can follow him on Twitter. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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