The VIX-linked ETNs showed their true colors last week, when the VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX) tanked following the news that its issuer, Credit Suisse (NYSE:CS), would begin reissuing creation units after its suspension of new issuance in early February.

TVIX began trading like a closed-end fund following the suspension, and its market price moved far above its net asset value as demand outstripped supply. Upon news that Credit Suisse would begin issuing creation units again, TVIX’s market value began to plunge back toward its NAV. TVIX closed Monday 5.4% above its NAV ($5.88 versus $5.56), creating the potential for more pain in this broken ETN. Here are the results from the past few days:

• Wednesday, 3/21: $14.43
• Thursday, 3/22: $10.20 (-29.3%)
• Friday, 3/23: $7.16 (-29.8%)
• Monday, 3/26: $6.34 (-17.9%)

Click to Enlarge Unfortunately, this isn’t the end of the story. Short-sellers also pressed their attack on other ETNs trading above their net asset value, including other VIX-linked products and the iPath Dow Jones UBS Natural Gas SubindexTotal Return ETN (NYSE:GAZ). GAZ, which has fallen more than 23% since the TVIX news hit last week, remained over 36% above its NAV at Monday’s close.

This isn’t the first time the volatility ETNs have run into trouble. These products have long failed to provide accurate tracking versus the VIX because of the effect of contango, or the higher prices for long-term VIX futures contracts relative to the widely quoted spot price. Since the VIX “curve” typically is steep — and has moved to a record slope in the past week — the volatility-tracking products were taking it on the chin even before Thursday’s news.

There are two important lessons here. First, the volatility ETNs are broken and need to be left alone.* Unfortunately, their ability to deliver exceptional returns at select times has drawn in traders like moths to a flame. Last fall, for instance, TVIX shot up from about $15 to more than $105 in just a little over two months when the market collapsed on the revival of the European debt crisis, reinforcing the status of these ETNs as a potential lottery ticket when the market falls. While this indeed has been the case, these rallies have been more than offset by their severe downturns when stocks were doing well — and that was even before the events of last week. The bottom line is that there are plenty of ways to bet against the market without taking on the added risks of TVIX and the other volatility ETNs.

Second, anyone who lumps ETFs and ETNs into the same basket needs to think again. This isn’t the first time an ETN has blown up — recall that three Lehman ETNs disappeared when the firm went under in 2008. The lesson is that ETNs, which are unsecured debt instruments that don’t hold own physical assets, have hidden dangers that investors need to take into account.

What’s the answer? If you aren’t already among those unfortunate to have taken a hit in the VIX ETNs in recent days, there are several steps you can employ to protect yourself:

1. Be sure to check the difference between the market price and net asset value of an ETN before considering an investment. It takes some digging, but ETNs each have a ticker for their NAVs. The TVIX ticker, for instance, can be found on Yahoo! Finance using ^TVIX-IV. The decline in TVIX could have been predicted, as the gap between its market value and NAV was there for all to see. Unfortunately, the majority of the financial media missed an opportunity to provide advance warning. Now, at least, investors can be better prepared for what occurs once an ETN’s price no longer corresponds to its NAV.
2. Be very wary of any ETN that isn’t effectively tracking the underlying index as intended. This disconnect has served as a warning sign in the past, and it’s likely to do so again.
3. If you decide to use an ETN to gain long exposure, consider shorting the inverse ETN rather than buying the long ETN. This way, at least you’ll be on the correct side if the ETN runs into trouble as the volatility products did last week. Also, if the opportunity exists to buy an ETF rather than an ETN, be sure to take advantage of it.

* Full disclosure: After warning about these products in June, I incorrectly recommended them for a short-term trade in December.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.