Exchange-Traded Notes Warning Signs
April 2, 2012

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, He can be reached at

Investors have been pouring money into exchange-traded notes, ETNs, with the inflows in the first two months of this year being 71% more than in all of last year. Recent developments, however, have underlined some of the risks that investors may face when using these instruments. In several March 29 Wall Street Journal articles, including “Chaos Over a Plunging Note” and “Rise of ETNs Comes with Tempered Enthusiasm,” the tale of a 60% plunge in value in just three days of Credit Suisse’s VelocityShares Daily 2X VIX Short-Term ETN, traded as TVIX, is told. The tale is a complex one, involving a complex instrument meant to track the stock market volatility index, VIX, and that is leveraged to provide investors twice as much as the daily move in the VIX. The SEC and the Commonwealth of Massachusetts are looking into the way this note was managed. We will not go into the details of this case here. Rather we will use it to illustrate why investors should use particular care in considering the addition of ETNs to their investments.

It is important, first and foremost, to understand that ETNs are a form of unsecured structured promissory obligation, backed by the credit of their issuing financial institutions. In other words, the investor is making an uncollateralized loan to the issuing institution. Unlike an exchange-traded fund (ETF), there is no underlying portfolio of securities to which a shareholder can lay claim, should the financial institution declare bankruptcy. This credit risk issue alone has led us at Cumberland Advisors to be very hesitant to use ETNs in our portfolios. We would need to determine first that there was no ETF available that would give us access to the target asset class and, second, that the credit risk involved was minimal.

Furthermore, the case mentioned above illustrates that credit risk is not the only danger. Much of the increased interest in ETNs involves complex instruments for use in hedging strategies. They are designed by sophisticated investment banks and are heavily used by sophisticated hedge funds. Less-sophisticated investors should be very wary of venturing into such waters. As pointed out by Samuel Lee in “Exchange-Traded Notes Are Worse Than You Think” on, “Unlike mutual funds and most ETFs, ETNs are not registered under the Investment Company Act of 1940, or the ’40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures.”

Investors need to read very carefully the ETN contracts, which can include significant unexpected costs. Samuel Lee, points out, for example, the use by some issuers of path-dependent fees that “create tracking error to the index depending on the index’s path.” The result is fees that spike upward most when the index being tracked drops the hardest. This certainly undermines the claim that ETNs are supposed to provide near perfect index tracking. (It should be added here that the VelocityShares ETN, TVIX, cited at the beginning of this Commentary, does not have path-dependent fees.) Other costs that may be encountered in addition to the advertised “investor fee” include “index calculations,” “event risk hedge costs,” “futures execution costs,” and “holding costs.” While touted as a low-cost instrument, an ETN can end up with fees in a range common to mutual funds.

Bill Witherell, Chief Global Economist

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