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Exchange-Traded Notes: The Unpleasant Side

Exchange-traded notes (ETNs) are complicated investments that come with a number of hidden and not-so-hidden risks for investors. On July 10, the Financial Industry Regulatory Authority (FINRA) issued an investor alert on the products, following an investigation sparked by sudden swings of the Credit Suisse and Barclays ETNs earlier this year.

“ETNs are complex products and can carry a raft of risks,” said Gerri Walsh, FINRA vice president for investor education, in the notice. “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.”

ETNs are a type of debt security that trade on exchanges and promise a return linked to a market index or other benchmark. Unlike exchange-traded funds (ETFs), however, ETNs do not buy or hold assets to replicate or approximate the performance of the underlying index. In addition, some of the indexes and investment strategies used by ETNs can be quite sophisticated and may not have much performance history.

Moreover, some leveraged, inverse and inverse leveraged ETNs are designed to be short-term trading tools; in other words, the performance of these types of ETNs over long periods can differ dramatically from the stated multiple of the performance (or inverse of the performance) of the underlying index or benchmark during the same period.

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, of a distribution if the ETN is held to maturity (as with some other structured products).

As reported July 10 by Investment News, other problems with ETNs can occur when a bank is forced to stop issuing new shares. That happens in instances where the maximum number of shares has been reached or the bank itself is no longer able to hedge effectively against the index. When no new shares are issued, the ETN then functions like a closed-end fund and continued demand can drive shares to a premium over the net asset value.

For example, the Credit Suisse VelocityShares Daily 2X VIX Short-Term ETN stopped issuing new shares in early 2012. As a result, the shares quickly doubled in value because of high demand. But when Credit Suisse Group AG began issuing shares one month later, the share price of the ETN suddenly collapsed back to the NAV and wiped out $172 million in one trading day.

Another ETN, Barclays’ iPath Dow Jones-UBS Natural Gas Total Return Sub-Index, saw the premium of its share price go to as high as 134% of its NAV in March. In that case, investors were paying more than $2 for $1 of the ETN’s exposure. Today it’s at a 32% premium.

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