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By: Costas Bocelli — October 31, 2012

One ETF You Never Want to Buy

Editor's Note:  Costas is cleaning up from this week's storm and was unable to submit a new article for today.  The below piece from this past March, however, should be a very useful one to our new readers, and a valuable reminder to everyone else.
Recently we got an ugly glimpse of the destructive capabilities that one type of ETF can unleash upon its victims.  This nightmare ETF has mostly ensnared and damaged individual investors like you and me.

Let me explain...

Investors have become increasingly enamored with volatility.  So much so that literally dozens of new ETF products have been rushed to market to quench this insatiable demand.

What’s extremely troubling is that these products are frequently unregulated, allowing the fund managers to literally write the rules as they go while reaping millions in fees and shady profits along the way.  What’s even scarier is that, under current securities law, their actions fall well within legal boundaries.

If there is one ETF product sector that you should avoid like the plague, it’s Volatility oriented exchange traded notes (ETNs).

They are flawed.  They are complex.  And worst of all you’re going up against fund managers who do not serve your best interest.  Essentially, you’re directly getting involved and going up against their proprietary trading book as they masquerade as market makers.

All it takes is a little research and due diligence on how these products actually work, and you’ll soon discover that they are being grossly misinterpreted by millions of investors.

Their make-up is a stark contrast to other popular ETFs like SPDR Gold Shares (GLD) and iShares Silver (SLV) where the funds' assets are backed by physical gold and silver bars.  Equity ETFs such as SPDR S&P500 (SPY) and iShares Russell 2000 (IWM) are backed and constantly rebalanced by the underlying stocks in precise proportions to mimic the indices.

But Volatility ETNs are an entirely different animal and must be actively managed.  There are subtle differences between the menu of products, but inherently they all exhibit similar characteristics, flaws and dangerous risks to individual investors.

The Phantom Menace

The big difference is Volatility in itself. 

Let’s get one thing straight: Volatility is not an asset class!  It’s a mathematical derived indicator that measures implied movements of an asset’s price. 

And most of the Volatility ETN products model some sort of variation of the widely followed VIX index that measures implied volatility on the S&P 500 index.

In a recent Tycoon Report article, Higher Volatility Coming Sooner Than You Think, we talked about the VIX itself as not being a tradable index, and serves merely as a “spot reference”.  But what are tradable are VIX futures and options on VIX futures.

We also noted the futures term structure along the time curve, which was and still is in very steep contango (visit CBOE Futures Exchange or click this link).

(By the way, the Contango Effect -- lower prices in nearer dated contracts versus higher prices in further dated contracts -- is a major flaw that undermines the valuations in volatility ETNs.)

This is the secret control room that’s behind the curtain and exposes all the problems with these products.  You see, as investors pile in or out of these ETNs, the fund managers are not swapping out tangible assets, stocks, or commodities to balance their book -- they’re swapping out futures and options that settle in cash, which is unlimited like a bottomless pit.  In other words, nothing real is collateralized.

In fact, if you dive into the prospectus on many of these Volatility ETNs, you’ll probably discover some pretty serious disclosures that would make you want to run for the hills. 

For instance, Volatility ETNs are backed by senior unsecure debt.  What this means is that since there are no collateralized assets backed by the shares created -- like gold, silver or stocks -- your investment is backed by the full faith and credit health of the investment fund.

This is the compelling reason that volatility funds really only care about three things: Drawing investor flow to their products, charging fees, and creating trading profits from active management.

And it’s an even more compelling reason for you to avoid them.

Tyrannosaurus VIX Shows His Teeth

Last Thursday, we got an unfortunate taste of how dangerous these products can truly be.  Many unsuspecting investors got caught holding the bag and were stuck with sizable losses.

The Velocity Shares daily 2x VIX Short-Term ETN (TVIX) is a double levered volatility product run by Credit Suisse.  The investment seeks to replicate twice the daily performance of the S&P 500 VIX short term futures. 

Basically, the product is trying to give investors twice the bang for their buck on the VIX index.  But, based on recent events, it appears that they may be more keen on trying to fleece investors twice as fast.

Let me explain...

Below is a two month daily chart on the TVIX.  It’s overlaid with the VIX, the index that it’s trying to replicate with double leverage.

Investors got TVIX’d...
The first sign of problems occurred back on February 21, identified by the red arrow on the chart.  Notice the heavy volume leading up to that date.  That activity is heavy accumulation of the ETN, where Credit Suisse was responsible for delivering the excess supply.  To cover his short exposure, the fund manager buys assets, which in this case are VIX futures.

After being forced to take on such a huge futures position and cover the TVIX shares sold to investors, the position got very big.  Remember, ETNs are backed by the institution, and essentially the risk managers over at Credit Suisse were getting uncomfortable.

So what did they do?  They simply stopped issuing more shares and stepped out of the way and let investors make the market.  This basically turned the product into a closed-end fund, which artificially created a huge premium from the overwhelming demand.

After the volume calmed down and March VIX futures contracts settled (which reduced their position size and risk exposure), Credit Suisse suddenly announced they were getting back in the game on March 22.  While the public announcement came after the close, the “smart money” got the early look and front ran the news that Credit Suisse was about to dilute the issue back to normal NAV (Green arrow).

In essence, they popped the premium balloon and let all the air out, sticking it to individual investors to the tune of nearly a 60% loss in two days while some “pretty smart” investors were selling ahead of the news and making out like bandits in the night.

The blue arrow simply shows the divergence (correlation breakdown) between the TVIX and the VIX over the past week.  That divergence is another unfortunate example of the dark side of Wall Street and how the system really works with such cruel intentions.

I’ll leave you with three quick takeaways:

  1. Unless you are a very short term active trader, it’s best to avoid volatility ETNs.
  2. Re-read my prior article on volatility (It’s linked above).  Use the information to help you frame your market sentiment.  You don’t have to risk one red cent, and you can still utilize the VIX to make money.
  3. If you do feel compelled to play these products, wait.  Be patient and take bearish positions when volatility spikes.  Use their flaws to your advantage.  It doesn’t happen very often, but buying some well placed Put options in the VXX can be a high probability juicy trade when the VIX spikes.

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