The Financial Industry Regulatory Authority (“FINRA”) recently issued an investor alert regarding exchange-traded notes (“ETNs”), which are often confused with similarly-named exchange-traded funds (“ETFs”), but can be fundamentally different.
ETNs are promissory notes made by an issuer that promise a return linked to the performance of an underlying index. ETNs do not make periodic interest payments to investors like traditional bonds do. Rather, ETN investors are promised a distribution amount, determined by the performance of the underlying index, when the ETN matures in 10, 30 or more years.
Like ETFs, ETNs trade on exchanges at prices determined by the market. ETNs differ from ETFs, in that, ETNs do not hold a basket of stocks or bonds to replicate the performance of the underlying index.
The indicative value of an ETN is calculated each day and is based on the underlying value of the index the ETN tracks. The indicative value is distinct from the ETN’s market price, which is the price at which the ETN trades on the secondary market.
Purchasing an ETN at a premium to the indicative value, and selling the ETN on the secondary market when the market price no longer reflects the premium, can cause an investor to incur significant losses.
This scenario can happen when an issuer stops issuing new shares, most often because the maximum number of shares permitted by the prospectus has been issued. When this happens, continued demand for the shares can drive the share price to a premium over the indicative value. The problem for investors occurs when the issuer later resumes issuing shares and the price collapses.
This happened recently with the Credit Suisse Velocity Shares Daily 2X VIX Short-Term ETN. Credit Suisse stopped issuing new shares of the ETN in February. High demand for the shares quickly drove up the price. When Credit Suisse resumed issuing shares the next month, the price quickly plummeted, wiping out $172 million in one day.
FINRA cautions that there are a number of risks to consider before investing in an ETN:
• Credit Risk – the issuer may default on the note
• Market Risk – the value of the ETN is susceptible to changes in the market value of the underlying index it tracks
• Liquidity Risk – it is possible that a trading market may not develop, or an issuer can delist an ETN
• Holding Period Risk – some ETNs are designed to be short-term investments (some as short as one day) and their performance can differ significantly from the stated performance objectives if held for longer periods
• Call Risk – some ETNs are callable at the issuer’s discretion leading to the possibility that an ETN could be called when the value is less than the investor paid
When considering purchasing an ETN, investors should consult an investment professional and tax adviser for a thorough and beneath-the-surface explanation of an ETN’s risks, benefits and potential tax consequences before adding it to their portfolio. ETNs may be a good choice in certain circumstances. These complex instruments, however, can prove disastrous when not suitable for investors without a clear understanding of the accompanying risks.
The Florida securities lawyers at McCabe Rabin, P.A. represent investors nationwide in FINRA arbitration matters. Investors nationwide who have incurred recoverable investment losses due to specific failures by stockbrokers and brokerage firms, and who may have a FINRA arbitration claim, may contact the Florida securities lawyers at McCabe Rabin, P.A. for a free and confidential consultation by calling toll free at 877.915.4040 or by e-mail to firstname.lastname@example.org.