Finra warns investors about exchange-traded notes in new alert

By Angela McDaniels

Tacoma, Wash., July 10 - The Financial Industry Regulatory Authority issued an investor alert called "Exchange-Traded Notes - Avoid Unpleasant Surprises."

"ETNs can offer investors convenient and cost-effective exposure to everything from commodities to emerging markets, but they can be complex and carry numerous risks - including the risk that the issuer will default on the note or take other actions that may impact the price of the ETN," Finra said in the alert.

Among other topics, the alert noted that ETNs are different from traditional bonds in that they typically do not pay interest and that unlike exchange-traded funds, ETNs do not buy or hold assets to replicate or approximate the performance of the underlying index.

Closing indicative value

Finra emphasized the different between an ETN's closing indicative value, which is computed by the issuer, and its market price.

"In theory, an ETN's market price should closely track its closing and intraday indicative values. However, an ETN's market price can deviate, sometimes significantly, from its indicative value," Finra said.

As an example of why price deviations might happen, Finra said an ETN might trade at a premium to its indicative value if the issuer suspends issuance of new notes. Paying a premium to purchase the ETN in the secondary market and then selling it when the market price no longer reflects the premium can lead to significant losses for an investor, Finra noted.

"This occurred recently when an ETN experienced price movement that diverged significantly from its indicative value and the performance of the index it tracks, due in part to suspensions in the issuance of new shares, which caused the ETN to trade at a significant premium - nearly 90%. When the issuer of the ETN resumed the creation of new shares, the market price of the ETN fell sharply - dropping by more than half in two days," Finra said.

Daily reset

Finra noted that some ETNs reset their leverage or inverse exposure on a daily basis.

"Given the daily resetting of its leverage factor, an ETN that is set up to deliver twice the performance of a benchmark on a daily basis will not necessarily deliver twice the performance of that benchmark over longer periods such as weeks, months or years," Finra said.

"Due to the effect of compounding, their performance over longer periods of time can differ significantly from the stated multiple of the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time."

Finra said leveraged and inverse ETNs are designed to be short-term trading tools and are not intended for buy-and-hold investing.

Trading

The alert said that market prices of ETNs may fluctuate due to movements in the indexes they track and other factors such as ETN creation and redemption activity.

When ETNs are trading at a premium to the indicative value, issuing more ETNs can bring the price down. Similarly, if ETNs are trading at a discount, a redemption by the issuer reduces the number of ETNs available in the market, which tends to raise the price, Finra said.

The alert noted that given the various steps in the process, transaction fees and the large number of ETNs required to initiate a redemption (usually 50,000), redemption is "not generally a practical source of liquidity for most retail investors."

Risks and considerations

Finra's alert encouraged investors to consider the following risks associates with ETNs:

• Credit risk;

• Market risk;

• Liquidity risk;

• Price-tracking risk;

• Holding-period risk;

• Call, early redemption and acceleration risk; and

• Conflicts of interest.

Finra also suggested that investors ask themselves the following questions:

• Who is the issuer?

• What index or benchmark does the ETN track?

• Is the ETN callable by the issuer?

• Does the ETN offer leveraged or inverse exposure to the underlying index or benchmark?

• What fees and costs are associated with the ETN?

• What are the tax consequences?

"ETNs are complex products and can carry a raft of risks. Investors considering ETNs should only invest if they are confident the ETN can help them meet their investment objectives and they fully understand and are comfortable with the risks," Gerri Walsh, Finra's vice president for investor education, said in a Finra news release.

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