Structure Matters (SM): Barclays decision to suspend creates for its VIX product, the iPath Series VIX Short Term Futures ETN, reminded me of the Think Tank Blog Post from July 2020 where we wrote ETNs are “Flawed” and “Should Go Away.” Those reading our weekly ETF KPIs will note that the pure number of outstanding products has shrunk to 103 from 135 (Peak of 172 in 2019). Additionally, the structure is now 3.45% of the overall AUM ETF wrappers, vs 5.95% back in 2020. Surprisingly, however, assets have grown from about $7.3 billion to $12.7 billion.
Why have ETN Assets Grown Since we Declared ETNs are Flawed?
The top 20 funds still represent the dominant sleeve of assets, at about 77-80%. Again, these assets are concentrated among 4-5 banks. JP Morgan, Barclays, UBS, and Credit Suisse have made it clear that this is not an area they see growing. BMO, however, seems excited about this business, and there are clear limitations to their expansion growth.
Investors need to consider why ETN assets have grown. First, to be clear, there remains a great deal of concentration in who the issuers are in terms of Exchange Traded Note (ETN) asset gatherers. Issuers of ETNs are actually bank debt structured products, so most issuers cannot play in this sandbox. The market for ETN issuers is concentrated across JP Morgan, Barclays, BMO, and UBS. Credit Suisse remains a small player. As many “ETF Nerds” recall, the Alerian Fund (AMJ, formerly YYY) came as a result of JP Morgan’s Bear Stearns rescue. Noteworthy is the fact that JP Morgan has held the number of notes outstanding static at 129 million since 2020, but 10 million are available for market making. According to the prospectus, “in June 2012, the maximum number of notes authorized for issuance were issued as of June 2012 and dating back to 2012 placed a cap on the number at 129 million according to SEC filings.” This means that the increase in AUM from July 2020 to today has been because of a rally in the MLP space rather than actual market share gains. The fund structured as an ETF, the Alerian ETF, in contrast has seen outstanding shares increase to 169 million from 152.22 million.
Ticker VXX Demonstrates that ETNS are Opaque Securities
Barclay’s decision to suspend creations on the iPath Series B S&P 500 VIX Short-term Futures ETN (VXX) and the iPath Pure Beta Crude Oil ETN (OIL) surprised traders. Originally it was believed that this decision was driven by concerns around volatility in these two asset classes. But to the surprise of many, including management at Barclays, the bank overextended itself on the issuance of its structure product business which includes ETNs. On Monday, according to a Reuters’ story, Barclays said it “offered and sold nearly twice as many affected securities over a period of about a year as it was registered to sell in the United States, overshooting its $20.8 billion limit by $15.2 billion.” This issue further highlights questions around the complexity of this wrapper and investors ability to rely on the structure. To that point, as the Reuters article highlights, since the bank is required to buy back these notes to shrink their outstanding exposure, it will take a $590 million loss. We have not heard the last of this banking blunder, and it would seem logical that growth of issuance will be challenged in the future as a result.
The fact is that investors today, who are owning VXX at a 23% premium, are taking on risk that can only be described as one sided in nature. By owning the security as a hedge against a market decline, investors may actually lose if the premium collapses due to action taken by Barclays to clean up its issues. Losing money on a winning trade because of a flawed structure can be most annoying!
Lastly, Bank of Montreal (BMO) seems like the only firm expanding in the ETN space. JP Morgan, Barclays, UBS, and Credit Suisse have made it clear this is not an area they see growing. BMO is the only bank that seems excited about this business, and there are clear limitations to their expansion growth.
Summary
There is a definite purpose behind ETNs, but investors should not confuse their structure as being the same as ETFs. We would argue that the complexity of the structure and arms-length nature of the relationship between investors and the product issuers is less transparent than with the standard ETF structure. Moreover, the management issue at Barclays will further put into question why other banks want to be involved in this business. Ironically, we think VIX futures are a good solution to lower volatility in a portfolio, they should not be counted on when wrapped in an ETN. ETNs are flawed and we think buyers should beware.
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