Exchange-Traded Products Can Be Risky

Exchange-Traded Products Can Be Risky

While fear of rising interest rates has clearly been a factor in recent market volatility, there are plenty of other reasons for the sudden jolts that are worrying investors.

Doug Kass, president of Seabreeze Partners Management Inc., is quoted on Mauldin Economics saying the recent record-breaking market plunge “likely was a function of the distorted, dangerous world of new investment products and strategies. … [T]he proliferation of short vol, volatility trending and risk parity strategies when combined with an explosion of leveraged ETFs and ETNs – many of which were derivatives of derivatives and had no business existing except to please gamblers – had altered the market structure … ”

In his column, “Kill the Quants,” New York Times best-selling author John Mauldin focuses especially on exchange traded notes (ETNs), explaining that one of their key features is that there has to be a bank or a guarantor on the note.

“Even though we’ve had at least two shortfall ETNs literally blow up and go to zero,” he wrote, “the investors in those funds are going to get ‘something.’ If you put in your withdrawal request while there was still a price, there is an extraordinarily good case that you are due your money.”

When the ETN fund doesn’t have any money, the bank that guaranteed it is “on the hook.”

100% Hedged Out

One of the ETNs that imploded was backed by Credit Suisse. Before the market opened on Feb. 5, the day of the 1,175 point drop in the Dow, Credit Suisse announced that 100% of its liabilities in the ETN had been hedged out.

“Of course,” Mauldin wrote,” they didn’t say hedged out to whom, and that will make us all wonder about counterparty risk; but we won’t have answers on that for a long time, and while a significant amount of money is involved, it is not life-threatening to a bank the size of Credit Suisse. More like annoying than life-threatening.”

The Wall Street Journal has also reported on the volatility in exchange-traded products.

“While exchange-traded funds have lowered the cost of investing and given individuals access to strategies once reserved for hedge funds and multibillion-dollar pensions,” The Journal reported, “the $5 trillion global industry has ventured into complex strategies, sometimes with disastrous results.”

Exchange-traded products that bet against Wall Street’s fear gauge lost more than 80% of their value, according to The Journal. As the previously calm volatility index surged, $1 trillion in market capitalization was erased.

The Securities and Exchange Commission has started examining exchange-traded products and has already questioned Credit Suisse about its VIX-related product, according to The Journal. Credit Suisse plans to shut down its exchange-traded product on Feb. 21.

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