FINRA Warns Investors on the Risks of Exchange Traded Notes

FINRA urges investors to make sure they understand the risks of ETNs.

To help investors avoid such unpleasant surprises, on July 10, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on ETNs.

As debt securities that trade on exchanges, ETNs can offer people an inexpensive and convenient way to invest in everything from commodities to emerging markets because their returns are linked to a market index or other benchmark, the Alert said. They can be complex and risky, however, and retail investors need to make sure they understand how ETNs function before they buy.

According to the Alert, ETNs carry credit risk, market risk, liquidity risk, price-tracking risk, and holding-period risk. They also carry call, early redemption and acceleration risk as well as the possibility of conflicts of interest between issuer and investor. The Alert is meant to inform investors about the features and risks of ETNs.

Generally issued by a bank or other financial institution, ETNs are unsecured debt obligations, the Alert said. Unlike traditional bonds, they usually don’t pay interest. The return is a payment the issuer promises the ETN holder. The amount is set by the performance of an underlying index or benchmark on the ETNs’ maturity date, which can be as long as 40 years from the date of issuance. Fees are deducted from the payment.

ETNs also differ from traditional bonds in that they trade on exchanges throughout the day. Their trading price is determined by the market, similar to stocks or Exchange Traded Funds (ETFs). Unlike ETFs, however, ETNs do not acquire assets with the goal of replicating the performance of the underlying index. While some issuers may refer to ETNs as shares, the Alert emphasized that they are unsecured debt obligations.

The returns on ETNs depend on the price changes if the ETN is traded – much like stocks and ETFs -- or on the promised payment if the ETN is held to maturity or redeemed.

Some of the indexes to which ETNs are linked may be unfamiliar to average investors. For instance, there are ETNs based on indexes for foreign currency and commodities like gold or oil, as well as ETNs linked to indexes that track emerging markets or market volatility. Some ETN investment strategies may be highly sophisticated and without performance history, the Alert said.

Leveraged and inverse ETNs ramp up the complexity. Leveraged ETNs promise to pay a multiple of the performance of the underlying index or benchmark. For example, an ETN that offers 2x-leverage promises to pay twice the performance of the index it tracks.

Inverse ETNs pay the opposite of the performance of the index, and leveraged-inverse ETNs pay a multiple of the opposite of the performance.

These kinds of ETNS -- leveraged, inverse or leveraged-inverse -- are structured to reach their objectives on a daily basis. They also typically reset their leverage, inverse target or inverse leverage every day.

The Alert pointed out that this daily resetting means that ETNs set up, for instance, to deliver twice the performance of an index every day will not necessarily meet this same goal over weeks, months or years. The effect of compounding means that over long periods, ETNs’ performance can diverge dramatically from the performance or inverse performance of their underlying index.

For the most part, leveraged and inverse ETNs are short-term trading tools. They are not intended for buy-and-hold investing. Other ETNs of this type, however, may have monthly resets or no resets at all, so the Alert noted that investors must take care to distinguish the types and understand how their performance may differ.

The Alert also explained indicative value. Financial institutions may issue and redeem ETNs as a way to keep their price in line with this target value. This value is calculated and published at the end of each day by the ETN issuer.

If an ETN is trading above the indicative value, the issuer can lower the price by issuing more notes, the Alert said. If an ETN is trading below the indicative value, an issuer may redeem notes, which tends to raise the price. The issuers have primary control over issuance and redemption and these decisions are at their sole discretion.

While investors can redeem their ETNs early by submitting a notice to the issuer, given the fees and the large number of ETNs required for redemption -- usually 25,000 or 50,000 -- ETNs are not a practical source of liquidity for most retail investors, the Alert said.

The indicative price of ETNs is different from its market price, which is the price at which ETNs trade in the secondary market. Although these prices should track each other closely, they can deviate significantly. For example, an ETN might trade at a premium to its indicative value if the issuer stops issuing new notes. Significant losses can result if an investor pays a premium over the indicative value in the secondary market and then sells when the market price no longer reflects the premium because the issuer has resumed issuing new notes.

Before trading in the secondary market, the Alert said, an investor should compare an ETN’s closing and intraday indicative values with the market price. You may want to ask your broker if the issuer has ceased issuing new notes. If it has, ask why and for how long. Ask what kinds of orders can be placed and what happens if an ETN stops trading on an exchange.

The Alert listed some of the risks associated with ETNs:

• Credit Risk: Issuers may default on the note causing investors to lose their entire investment.
• Market Risk: The value of an ETN depends on the value of the index it tracks, which of course is subject to market forces. An ETN exposes investors to market risk, which is generally not the case with traditional corporate debt.
• Liquidity Risk: A trading market may not develop for ETNs. Also, an issuer might de-list an ETN, causing the market to completely disappear.
• Price-Tracking Risk: Investors need to be wary of buying ETNs at prices much different from the closing and intraday indicative values.
• Holding-Period Risk: Compounding means that over time, the performance of leveraged, inverse, and leveraged-inverse ETNs can widely diverge from the stated multiple of the performance or inverse of the performance of the underlying index.
• Call, Early Redemption and Acceleration Risk: Some ETNs can be called at the issuer's discretion. They may also be subject to early redemption or an accelerated maturity date. If their value when called is less than the market price paid, investors will lose part of their money. They will lose all their money if the value when called is zero.
• Conflicts of Interest: The issuer may engage in strategies like shorting that put them at odds with the investors who hold the ETNs. Investors need to check the prospectus for any mention of such conflicts so they can decide whether they are worth the risk.

Finally, the Alert said before investors purchase ETNs, they should identify the issuer and know its credit rating and overall financial health. Investors should also be aware of the index or benchmark tracked by the ETN. If investors are not familiar with the market or the asset class, they need to make sure they can adequately assess the risks involved.

For more details see the full FINRA Alert.

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