Taking Notes

There has been a mercurial rise in volumes and demand for exchange-traded funds in the past five years. New products usually take time to catch on with exchanges incentivizing initial liquidity providers. But the popularity of highly liquid, low fee instruments that mimic or track popular indices like the S&P 500 cannot be ignored.



But not every exchange-traded product is the same. And until the past month essentially, most investors on a retail to proprietary trading scale failed to see the implications associated with exchange-traded notes. One of the most popular exchange-traded products is VXX or the iPath S&P 500 VIX Short-Term Futures ETN. That ETN was doing just fine until a note trading under the symbol TVIX, VelocityShares Daily 2x VIX Short-Term ETN, crashed nearly 25% in one day.



That crash prompted the media and in turn, regulators, to examine exchange-traded products and their impact on the marketplace. The Securities and Exchange Commission as well as FINRA said that they were opening an investigation into exchange-traded notes. ETFs would remain relatively unscathed. ETNs are essentially unsecured bank debt loans not backed by assets whereas ETFs carry actual underlying assets.



Volatility-focused ETNs in particular are under scrutiny due to rebalancing issues and their correlation (or lack thereof) to their underlying indices. Independent trader Adam Warner summed up one of the problems encountered with TVIX, saying that “this isn't a delayed tweet....$TVIX came in today 15% above NAV, is probably pushing 20% above now.”



The CBOE Volatility Index (VIX), the de facto equity standard in measuring volatility, has remained depressed for over three months now and currently sits around 15. The VIX has fallen about 33% year-to-date whereas exchange-traded products looking to mimic the VIX have fallen even greater: UVXY and TVIX are down 80% and 72% YTD, respectively.