Special Risks Associated with ETN & Leveraged ETF Short Sales
Introduction
While account holders are always at risk of having a short security position closed out if
Overview
As background, an ETF is a security organized as a pooled investment vehicle that can offer diversified exposure or track a particular index by investing in stocks, bonds, commodities, currencies, options or a blend of assets. An ETF is similar to a mutual fund in that each share of an ETF represents an undivided interest in the underlying assets of the fund. However, unlike a mutual fund in which orders are only processed at a price determined at the end of the day, ETF shares are repriced and trade throughout the day on an exchange. To balance the supply and demand of shares and ensure that secondary market prices approximate the market value of the underlying assets, ETF issuers allow Authorized Participants (typically large broker-dealers) to create and redeem ETF shares in large blocks, typically 50,000 to 100,000 shares. While many ETFs invest solely in securities, others use debt or derivatives to track and/or magnify exposure to an index. The ProShares Ultra VIX Short-Term Futures ETF (UVXY) is one example of a widely-traded leveraged ETF.
ETNs are also securities that are repriced and trade throughout the day on an exchange and are designed to provide investors with a return that corresponds to an index. Unlike ETFs, however, ETNs are unsecured debt instruments and do not represent an interest in an underlying pool of assets. They do not pay interest like traditional debit instruments, but rather a promise to pay a specific return that typically corresponds to an index or benchmark. The iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) is one example of a widely traded ETN.
The supply of shares available to borrow in order to initiate or maintain a short sale position may be less stable for certain leveraged ETFs and ETNs, including UVXY and VXX, due to the following factors:
Limited Authorized Participants
The number of Authorized Participants willing to issue ETFs, particularly those that invest in derivatives (e.g., futures contracts, swap agreements and forward contracts) rather than securities and seek performance equal to a multiple (i.e., 2x) or an inverse multiple (i.e., -2x) of a benchmark may be limited. Moreover, Authorized Participants have no legal obligation to create shares and may elect not to do so to minimize their exposure as a dealer.
No Authorized Participants
As ETN shares represent credit instruments, the supply of such shares is determined solely by the issuing financial institution and Authorized Participants are not involved with the creation or redemption of shares. The ETN issuer typically reserves the right to limit, restrict or stop selling additional shares at any time.
Limited Holding Period
Certain leveraged ETFs and ETNs seek to match the performance of a benchmark index for a single day rather than an extended period. They are principally used by institutional investors and other traders looking to obtain short-term exposure to an asset class, hedge other investments in a portfolio or invest as a way to gain interim exposure to a particular market while gradually investing directly in that market. These factors can result in a higher rate of turnover and less stability of share inventory available to lend for short sales.
Margin Considerations
Shares made available for lending to short sellers often originate from brokers who maintain a lien on the shares as they’ve financed the purchase of the shares on behalf of clients via margin loans. Clients purchasing shares using borrowed funds are subject to regulatory margin requirements, compliance to which depends in part upon the value of the shares supporting the loan. As certain leveraged ETFs/ETNs are designed to provide returns in multiples of their benchmark, the inherent volatility of these products may diminish clients’ ability to maintain the position and, in turn, the broker’s ability to lend the shares.
To learn more about these products:
• Watch the lesson Intro to Leveraged & Inverse ETFs at Traders' Academy
• Read the article Risks of Volatility Products in
Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account.
Any discussion or mention of an ETF is not to be construed as a recommendation, promotion or solicitation. All investors should review and consider associated investment risks, charges and expenses of the investment company or fund prior to investing. Before acting on this material, you should consider whether it is suitable for your particular circumstances and as necessary, seek professional advice.
Complex or Leveraged Exchange-Traded Products are complicated instruments that should only be used by sophisticated investors who fully understand the terms, investment strategy, and risks associated with the products.
Investing in Exchange-Traded Notes (ETNs) involves significant risks and may not be suitable for all investors. ETNs are unsecured debt securities issued by financial institutions, and their value is linked to the performance of a specific index or benchmark. Before investing, carefully consider your investment objectives, risk tolerance, and consult with a financial advisor. Past performance is not indicative of future results.
Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.