Wednesday, July 25, 2012

FINRA Issues Warning on ETNs

By Olivia Wang, PhD

The Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert regarding the risks of exchange-traded notes (ETNs).

ETNs are a type of unsecured debt instrument typically issued by banks and other financial institutions. Similar to its close cousin the exchange-traded fund (ETF), ETNs track the returns of a specified asset class--often an index. However, unlike ETFs, ETNs do not hold actual assets tracked by the underlying index. This means investors in ETNs can suffer significant loss if the ETN issuer defaults, as there are no assets to recover, only the creditworthiness of the issuer itself. Issuers of ETNs compute the so-called "indicative value" based on the index price the ETN tracks. Theoretically the market price of the ETN should closely track the indicative value, but recent ETN market has witnessed quite dramatic deviation of the market price from the indicative value.

FINRA points out that investing in ETNs involve various types of risks. Probably the most prominent risk is the credit risk as we pointed out before. Other than that, market fluctuation might lead to change in the benchmark index with adverse effect on the ETN investment, generating substantial market risk. Also, despite the fact that ETNs trade on exchanges, there might still be a lack of liquid market for some ETNs. If an ETN is leveraged, inverse, or inverse-leveraged, investors could also be subject to holding-period risk due to compounding effects. Callable ETNs or ETNs subject to early redemption bear extra risk.

FINRA specifically warned about the risk that "the issuer will default on the note or take other actions that may impact the price of the ETN." One recent example was the roller-coaster price movement experienced by TVIX, a leveraged ETN issued by VelocityShares, Credit Suisse's ETF/ETN brand. TVIX is a member of a large family called "volatility-related ETPs, " which are exchange-traded products based on VIX, the S&P 500 volatility index complied by Chicago Board Options Exchange (CBOE). TVIX attempts to provide a daily return which is twice of the return of a daily rolling portfolio in both the first and second month VIX futures. As we discussed before on this blog, after Credit Suisse announced its decision to stop creating new shares of TVIX on February 21, TVIX started to trade at a huge premium over its indicative value. At its peak the premium exceeded 80% of the indicative value. The wide gap between the market price and the indicative value only dissipated after Credit Suisse decided to issue new shares again on a limited basis on March 22.

In the Investor Alert, FINRA warns that "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. " Therefore, FINRA advises investors to compare an ETN's indicative value with the its market price before making purchase decisions. Other factors that should be taken into account, as FINRA points out, include the ETN issuer, the index the ETN tracks, whether the ETN is callable, whether the ETN is leveraged and if so, how frequently it is rebalanced, the cost and fee structure, and the tax consequences.

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