|TVIX. Question here is why any one would buy such an instrument in the knowledge that NAV was so far out of whack - assuming of course that NAV was indeed posted.|
Chaos Over a Plunging Note Complex Security Drops 60% in Value in Past Week; SEC Is on the Case
By TOM LAURICELLA, JEAN EAGLESHAM and CHRIS DIETERICH
Regulators are examining volatile trading in a complex exchange-traded note that caused it to lose 60% of its value in the past week, Tom Lauricella reports on Markets Hub. (Photo: Reuters/Brendan McDermid)
Regulators are examining volatile trading in a complex exchange-traded note that caused it to lose 60% of its value in the past week.
The Securities and Exchange Commission is looking into the VelocityShares 2x Long VIX Short Term Exchange note, managed by Credit Suisse Group AG, which had about $700 million in assets before the decline, according to people familiar with the matter. The SEC review is preliminary, the people said.
The scrutiny comes amid rising investor alarm and confusion over trading in exchange-traded notes. The Credit Suisse note, which trades as TVIX and is designed to track stock-market volatility, plunged 29% on Thursday last week and then another 30% on Friday, even though market volatility was little changed. Another exchange-traded note, a Barclays Capital product designed to track natural gas, plunged this week for reasons that investors say remain unclear.
Spokeswomen for Credit Suisse and Barclays declined to comment.
Market observers say the confusion underscores the risky nature of exchange-traded notes. While hedge funds are usually the most active traders of the securities, the notes have become more popular with smaller investors, in part because they are low cost and easy to trade.
Another type of securities, exchange-traded funds, have exploded in popularity for similar reasons.
But what looks like a plain-vanilla instrument can have pitfalls, said Samuel Lee, an analyst at Morningstar Inc. who follows exchange-traded investments. "It's an issue of financial innovation opening up these esoteric markets and allowing individual investors pile into them faster than the regulators can keep up," Mr. Lee said.
On the surface, exchange-traded notes, widely known as ETNs, appear similar to exchange-traded funds, which trade like stocks on an exchange. But the inner workings of ETNs are more complicated. An ETN doesn't actually hold any underlying investment as an exchange-traded fund, or ETF, would. Instead, an ETN is contractual agreement by the issuer to pay shareholders returns equal to the investments it is designed to track.
Adding to complexity of this situation, the Credit Suisse ETN is linked to the Chicago Board Options Exchange Volatility Index, or VIX. That index, which is based on options prices, can experience wild swings. The Credit Suisse ETN is designed to magnify that volatility; investors make or lose twice as much as the daily move in the VIX.
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Similar "leveraged" products have been the subject of scrutiny before. During late 2008 and again last summer, they were blamed by some for fueling late-day swings in stock prices.
Industry participants say the troubles in the Credit Suisse offering started in February as it approached $700 million in assets, a quadrupling from the beginning of the year, and became too big for the market it was trying to track. Then, as the bank scrambled to manage the problem, it set off a chain of events that led to the price collapse.
Meanwhile, the fund was required to rebalance its portfolio at the close of trading each day based on moves in the VIX. Because traders knew that, they could profit by buying or selling before the fund, pushing prices higher and costing the bank more. As well, traders speculate that Credit Suisse was pushing up against firm-wide limits for futures positions or derivatives related to the fund.
Dean Curnutt at Macro Risk Advisors figures that in early March the Credit Suisse fund had to trade the equivalent of 3,300 VIX futures contracts daily, or about 4% of the entire day's volume. "Those are decent-sized numbers," said Mr. Curnutt.
On Feb. 21, Credit Suisse stopped issuing new shares in the ETN "due to internal limits on the size of ETNs." The announcement carried a warning that the move "may cause an imbalance of supply and demand" in the ETN's shares.
But some investors continued to buy shares of the fund, driving up the share price even as the VIX itself was falling. As a result, there was a steadily widening gap between the share price and its net asset value based on the level of the VIX.
On March 21, shares of the ETN closed at $14.43, 89% higher than its $7.62 net asset value, according FactSet Research.
Hedge funds saw an opportunity and began aggressively betting the shares would decline. After Credit Suisse stopped issuing new shares, the number of the ETN's shares borrowed by short sellers nearly quadrupled overnight, from nearly 600,000 on Feb. 21 to about 2.2 million a day later, according to Data Explorers. By March 22, the number of shares borrowed had jumped to 4.1 million.
But individual investors such as Eric Brehm, owner of a medical-supply distribution business in Sunnyvale, Texas, were in the dark. Back on Feb. 22, he had bought 2,200 of the shares for $17.30 each. It "was a way to hedge if the market took a big drop and offset my losses in other securities," the 59-year old Mr. Brehm said.
Seemingly out of nowhere on March 22, the share price for the ETN went into a free fall, losing 29% on its way down to $10.20. That evening, Credit Suisse announced it would issue new shares of the ETN on a limited basis, raising eyebrows among traders who wondered if word of the move leaked out. Over the next two days it would fall further, closing at $5.88 on March 26, before rebounding slightly to $7.20 on Wednesday.
—Ben Levisohn contributed to this article.