On July 10, 2012, the Financial Industry Regulatory Authority, Inc. (“FINRA”) published an investor alert titled “Exchange-Traded Notes—Avoid Unpleasant Surprises.” The investor alert can be found at: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P131262. The investor alert describes the features of a typical exchange-traded note (“ETN”) and also focuses on areas of concern to FINRA.
Leveraged and Inverse ETNs
The investor alert describes how leveraged and inverse features of certain ETNs may be confusing to non-professional investors. Because of the related “reset” feature, which may be daily or monthly, the performance of a two times leveraged (including a two times leveraged inverse) ETN will not be the same as two times the performance (or two times the inverse performance) of the underlying asset. Consequently, FINRA points out that ETNs with leveraged or inverse features are more appropriate as short-term trading tools and should not be purchased by “buy and hold” investors.
This portion of the investor alert revisits concerns about leveraged and inverse exchange traded funds raised by FINRA in its investor alert dated August 18, 2009.1
ETN Market Price Deviation
FINRA also warned ETN investors that they should compare the closing and intraday indicative values of an ETN, which are calculated and published by the issuer, or an agent or affiliate of the issuer, with the ETN’s market value. The indicative prices are calculated based on the value of the underlying asset; they do not take into account other factors, such as supply and demand of the ETNs. Investors should be alert to ETNs that are trading at a premium—i.e., the market value is significantly higher than the closing or intraday indicative value of the ETN. If the ETN is trading at a premium, there is a danger that the price may drop suddenly and precipitously, as was the case with the Credit Suisse AG Velocity Shares 2x Long VIX Short Term ETNs (TVIX) in March 2012.2
ETN Risk Factors
The investor alert summarizes risks applicable to ETNs, many of which are applicable to other structured products:
- Credit risk—ETNs are unsecured debt obligations of the issuer;
- Market risk—changes in the level or value of the underlying asset will affect the value of the ETN;
- Liquidity risk—although exchange-traded, a secondary market may not develop;
- Price-tracking—the market value of the ETN may become inflated, or unhinged from the underlying asset;
- Holding period—some ETNs, particularly leveraged and inverse ETNs, are designed as short-term trading tools and should not be held for long periods;
- Call, redemption and acceleration risk—some ETNs may be called by the issuer or accelerated in certain events; and
- Conflicts of interest—the issuer’s hedging activity is in potential conflict with the interests of the ETN holder.
Most ETN prospectuses disclose the risks highlighted in the investor alert, and other risks.
FINRA is warning investors that most ETNs are designed for investment professionals and should not be purchased by unsophisticated investors as a buy and hold type investment. Investors should be aware that although ETNs are traded on an exchange, typically the NYSE, they are not always a good investment for non-professionals.