Personal Finance: Don't buy investment until you understand it

Personal Finance: Don't buy investment until you understand it

May 2nd, 2012 by Travis Flenniken in Business Diary

Exchange-traded notes, or ETNs, are unsecured debt facilities that trade like a stock and offer investors returns based on a particular index.

ETNs, not to be confused with exchange-traded funds, or ETFs, can be highly complex. Investors should make sure they understand how an ETN is designed before using one. While they may seem like a good way to profit on a hunch, their complexity could cause an investor to lose money, even if they've made the correct call.

The VelocityShares Daily 2X VIX Short-term ETN is a security that is supposed to increase in value when the stock market gets volatile, i.e. sells off. This ETN, symbol TVIX, is designed to track an index called the VIX, which generally goes up when the S&P 500 goes down. The TVIX was created by Credit Suisse, and is designed to be hypersensitive to moves in the S&P 500 because of its use of leverage.

On March 20, TVIX traded at $15.13 per share; four business days later it closed at $5.60, losing over 60 percent of its value.

However the VIX, the index which it was designed to track, was basically unchanged during that same period.

So what happened? Why the disconnect between the investment and the index? Many investors, including state and federal regulators, are asking the same questions.

Most ETNs are designed to function like a mutual fund or an ETF by constantly creating and redeeming shares to allow the fund to meet market demand. If new shares cannot be created, it offsets the balance between value of the assets in the fund and the price investors pay for it.

As a result of Credit Suisse's impromptu policy change, investors that were buying shares of TVIX were paying a price that was approximately 80 percent higher than the assets it was holding.

What was the smart money doing after Credit Suisse stopped issuing new shares? According to SunGard's Astec Analytics, short sellers immediately began shorting the stock, assuming the Swiss bank would eventually resume issuing new shares. Following the halt in February, the number of TVIX shares being shorted shot up from 600,000 to over 2.2 million the next day, according to Data Explorers. Before the stock eventually cratered the next month, the number of shorted TVIX shares had jumped to 4.1 million.

The price of TVIX shares inexplicably dropped 30 percent on March 22, closing at $10.20 per share. After the market closed, Credit Suisse announced that it would resume the issuance of new shares. This action was sure to send the stock price back down to equilibrium with its underlying assets. The stock continued its descent until it bottomed at $5.90, two trading days after the announcement.

The timing of the selloff prior to the press release has caught the interest of the SEC and state securities regulators. Regulators are looking into who may have known about the announcement before the market close and could have benefited from the drastic drop in price.

If you don't understand an investment product, don't buy it. This is one of the lessons to be gleaned from the recent actions of TVIX. The information in the prospectus created by Credit Suisse should be enough to give anyone pause. As one clause in the TVIX offering materials reads, "The long-term expected value of your ETN is zero. If you hold your ETN as a long-term investment, it is likely that you will lose all or a substantial portion of your investment."

Buying TXIV may be a great way for traders to benefit from a short-term increase in volatility; but TVIX and others like it could be disastrous for investors who don't understand the function and purpose of such securities.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken is a Chartered Financial Analyst for Campbell Asset Management, LLC