Exchange-Traded Notes—Avoid Unpleasant Surprises
It is important to understand what exchange-traded notes (ETNs) are and how they work before you consider investing in them to avoid unpleasant surprises.
ETNs are a type of debt security that trade on exchanges and promise a return linked to a market index or other benchmark. 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 is issuing this Alert to inform investors of the features and some particular risks of ETNs—and to suggest questions to ask when considering investing in these products. While the names may sound alike, investors should understand that ETNs and exchange-traded funds (ETFs) differ in some fundamental and important ways.
What Are ETNs?
ETNs are unsecured debt obligations of the issuer—typically a bank or another financial institution. They are, however, different from traditional bonds. For example, unlike traditional bonds, ETNs typically do not pay any interest payments to investors. Instead, the issuer promises to pay the holder of the ETN an amount determined by the performance of the underlying index or benchmark on the ETN’s maturity date (typically 10, 30 or in some cases even 40 years from issuance), minus any specified fees. In addition, unlike traditional bonds, ETNs trade on exchanges throughout the day at prices determined by the market, similar to stocks or ETFs. But unlike ETFs, ETNs do not buy or hold assets to replicate or approximate the performance of the underlying index. Although investors may come across materials that refer to ETNs as shares, they are in fact unsecured debt obligations.
Some ETNs provide exposure to familiar, broad-based indexes, while others do so to less familiar asset classes or newer, more complex, or even proprietary indexes. For example, there are ETNs linked to indexes that track emerging markets, commodities such as gold and oil, foreign currencies and market volatility. Some of the indexes and investment strategies used by ETNs can be quite sophisticated and may not have much performance history. The return on an ETN generally depends on price changes if the ETN is sold prior to maturity (as with stocks or ETFs)—or on the payment, if any, if the ETN is held to maturity or redeemed (as with some other structured products).
Leveraged and Inverse ETNs
Some ETNs offer leveraged exposure to the index or benchmark they track. This means that they promise to pay a multiple of the performance of the underlying index or benchmark. For example, an ETN that offers two times—or "2x"—leverage promises to pay twice the performance the index it tracks.
Inverse ETNs offer to pay the opposite of the performance of the index or benchmark they track, and leveraged inverse ETNs seek to pay a multiple of the opposite of the performance of the index or benchmark they track. Some leveraged, inverse or leveraged inverse ETNs are designed to achieve their stated performance objectives on a daily basis and "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. 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.
Generally, leveraged and inverse ETNs are designed to be short-term trading tools and are not intended for buy-and-hold investing. Other leveraged, inverse or leveraged inverse ETNs can have monthly resets or even no resets, so it is important to distinguish one type from another and understand how their performance may differ.
ETN Trading, Issuance and Redemption
ETNs list on an exchange and can be bought and sold at market prices, similar to other exchange-traded investments. Market prices of ETNs may fluctuate due to movements in the indexes they track, as well as other factors, including ETN issuances and redemption activity.
Issuers of ETNs issue and redeem notes as a means to keep the ETN’s price in line with a calculated value, called the indicative value or closing indicative value for ETNs. This value is calculated and published at the end of each day by the ETN issuer. When an ETN is trading at a premium above the indicative value, issuing more notes to the market can bring the price down. Similarly, if an ETN is trading at a discount, redemption of notes by the issuer reduces the number of notes available in the market, which tends to raise the price.
ETN issuers have primary control over the issuance and redemption processes in the ETN market. The decision to issue additional notes is at the issuer’s sole discretion. Investors may initiate the redemption process prior to an ETN’s maturity date, following precise steps laid out by the issuer in the prospectus. The process generally begins by submitting a "notice of redemption" form to the issuer. Given the various steps in the process, transaction fees—and especially the large number of ETNs required to initiate a redemption (usually 25,000 or 50,000)—redemption is not generally a practical source of liquidity for most retail investors.
If a redemption occurs, the issuer will redeem the notes at the ETN’s indicative value. Indicative values are generally based on the value of the underlying index or benchmark, minus certain fees (sometimes referred to as "daily investor fees"), which vary across ETNs and can fluctuate for a given ETN. ETNs also typically have an intraday indicative value that is calculated and published every 15 seconds during the trading day under the applicable trading symbol by the market in which the ETN trades. Each ETN uses its own formula for computing its indicative value, which is generally outlined in the ETN’s prospectus or pricing supplement.
Indicative Value and Market Price—Be Alert When There is Significant Deviation
An ETN’s closing indicative value, as well as its intraday indicative value, are distinct from an ETN’s market price, which is the price at which an ETN trades in the secondary market. 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.
Price deviations can happen for a variety of reasons. For example, an ETN might trade at a premium to its indicative value if the issuer suspends issuance of new notes. Paying a premium relative to the indicative value to purchase the ETN in the secondary market—and then selling the ETN when the market price no longer reflects the premium—can lead to significant losses for an investor. This occurred 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 notes, which caused the ETN to trade at a significant premium—nearly 90 percent. When the issuer of the ETN resumed the issuance of new notes, the market price of the ETN fell sharply—dropping by more than half in two days.
For this reason, before trading in the secondary market, it’s a good idea to compare an ETN’s closing and intraday indicative values with the market price. If the ETN is trading at a significant premium to its closing or intraday indicative value, you might want to consider similar products that are not trading at a premium, or that provide similar expose to the index or asset class. It’s also a good idea to ask whether the issuer has suspended issuing new notes, and if so, why. Find out from your broker what type of orders you may place for the ETN and what will happen if it is no longer listed on an exchange.
Risks to Consider
There are a number of risks associated with ETNs, including:
- Credit Risk. ETNs are unsecured debt obligations of the issuer. If the issuer defaults on the note, investors may lose some or all of their investment.
- Market Risk. ETNs are market-linked: the value of an ETN is largely influenced by the value of the index it tracks. As an index's value changes with market forces, so will the value of the ETN in general, which can result in a loss of principal to investors. Thus, in addition to credit risk, an ETN subjects investors to market risk, which is generally not assumed by investors in traditional corporate debt. Also, make sure you understand what the index being tracked by the ETN is measuring—for example, some indices reflect a dynamic trading strategy and others are based on futures markets. Also, some indices reflect "total returns" while others may not.
- Liquidity Risk. Although ETNs are exchange-traded, they do carry some liquidity risk. As with other exchange-traded products, a trading market may not develop. In addition, under some circumstances, issuers can delist an ETN. If this happens, the market for the ETN can dry up or evaporate entirely.
- Price-Tracking Risk. ETNs, like other exchange-traded products, typically trade at prices that closely track their indicative values, but this might not always be the case. When trading in the secondary market, check market prices against indicative values, and be wary of buying at a price that varies significantly from closing and intraday indicative values.
- Holding-Period Risk. Some ETNs, particularly some leveraged, inverse and inverse leveraged ETNs, are designed to be short-term trading tools (with holding periods as short as one day) rather than buy-and-hold investments. Because of the effects of compounding, the performance of these products over long periods can differ significantly from the stated multiple of the performance (or inverse of the performance) of the underlying index or benchmark during the same period.
- Call, Early Redemption and Acceleration Risk. Some ETNs are callable at the issuer's discretion. In some instances ETNs can be subject to early redemption or an "accelerated" maturity date at the discretion of the issuer or one of its affiliates. Since ETNs may be called at any time, their value when called may be less than the market price that you paid or even zero, resulting in a partial or total loss of your investment.
- Conflicts of Interest. There are a number of potential conflicts of interest between you and the issuer of these products. For example, the issuer of the notes may engage in trading activities that are at odds with investors who hold the notes (shorting strategies, for instance). Search the ETN's prospectus for any mention of "conflicts of interest" and evaluate whether these conflicts are worth the risk.
Before You Invest
Make sure you have answers to the following questions so that you can better assess whether an ETN investment is right for you:
- Who is the issuer? Once you know, be sure to research the issuer’s credit rating and financial situation. If the issuer is publicly traded, use the SEC's EDGAR database. Keep in mind that ETNs are not registered investment companies and therefore are not subject to the same registration, disclosure and other regulatory requirements as most ETFs or mutual funds.
- What index or benchmark does the ETN track? If it involves an unfamiliar market or asset class, ask yourself whether you feel informed enough about the market or asset to effectively assess the risks involved.
- Is the ETN callable by the issuer? You can find this out by reading the prospectus or asking your financial professional.
- Does the ETN offer leveraged or inverse exposure to the underlying index or benchmark? If so, how frequently does it "reset"? One clue may be in the ETN’s name: words like "daily" and "short-term" often indicate that the product resets daily and is not intended to be held for long periods of time.
- What fees and costs are associated with the ETN? ETNs differ widely with respect to fees, including the investor fee charged in connection with redemptions. Read the prospectus and ask your investment professional to clearly explain any fees and expenses associated with a given ETN.
- What are the tax consequences? The tax treatment of ETNs can vary depending on the nature of the ETN. Check with your tax advisor if you are unsure about the tax implications of a particular investment.
As with all investments, it pays to do your own homework regarding ETNs. Only invest if you are confident the ETN can help you meet your investment objectives and you are knowledgeable and comfortable with the risks associated with the investment.
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