FINRA Issues Warning About ETNs
ETNs, a class of exchange-traded products that has garnered a fair amount of attention this year for all the wrong reasons, can sometimes put investors’ interests at odds with those of the financial institutions that back them, FINRA, the financial industry’s self-regulating authority, warned this week.
FINRA’s “Investor Alert” comes as Credit Suisse, the bank behind the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), is facing a class action suit for allegedly failing to properly inform investors of the nuances of the security. VelocityShares, which runs the ETN, declined to comment on the suit.
ETNs are often confused with ETFs, as both employ the creation and redemption mechanism that is often cited as a major reason why $1.183 trillion is now invested in U.S.-listed exchange-traded products . ETNs and ETFs can also similarly track broad indexes, though ETNs are known for the way they serve up exposure to obscure corners of the investment universe, such as volatility and leverage.
“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,” the regulator’s warning said. “While the names may sound alike, investors should also understand that ETNs and exchange-traded funds (ETFs) differ in some fundamental and important ways.”
ETNs, or exchange-traded notes, are debt obligations, while ETFs are pools of actual assets. That means investors can lose their entire investments should the bank committing to pay investors the returns of a given index go bankrupt. That actually happened with three ETNs sponsored by Lehman Brothers, when that firm filed for bankruptcy in 2008, though the dollar amounts were rather small.
Such a dire bankruptcy-related outcome is simply not possible with an ETF, as investors actually own the underlying assets held in the ETF, and that wouldn’t change if a given fund sponsor’s finances hit rocky shoals.
The FINRA note didn’t call for any regulatory action, but rather had a sober “buyer beware” flavor, imploring investors and advisors to do their homework so that they know what they’re getting into.
Applauding FINRA
Barclays, the biggest ETN company, which backs the iPath family of securities, declined to comment on the FINRA note. Barclays had assets of $6.85 billion in its family of 81 ETNs, according to IndexUniverse’s daily “League Table .”
That compliance-related reticence is to be expected, according to Richard Keary, head of Global ETF Advisors LLC, who thought the note had a solid and much-needed educational tone.
“I think this note is great and I applaud FINRA for it,” Keary said in a telephone interview. “It’s helping to educate advisors on what an ETN is.”
Keary, whose New York-based firm advises companies planning to launch ETFs, said the ETN industry has been alone in its education effort, which makes FINRA’s note that much more valuable.
“To have the regulator help in that educational outreach process benefits investors and the industry. They’re great products, and it’s great to know better how to use them,” Keary said, adding that he thinks the industry has done a decent job communicating the message.
Shutting Creations
Much of the controversy surrounding ETNs has to do with the way the creation mechanism has broken down on hugely popular securities—most recently on securities such as TVIX and the JPMorgan Alerian MLP ETN (AMJ).
Both ETNs shut creations in the face of strong investor interest, and both subsequently began trading at premiums to their net asset values—much like closed-end funds—undermining the virtues of the creation/redemption mechanism that keeps ETFs and ETNs trading at or very near their NAVs.
Industry sources have told IndexUniverse that hedging needs grew too rapidly for the ETNs’ backers, making risk management too much of a moving target, and forcing them to turn off the tap as assets kept flowing in.
Moreover, the closing of creations by ETNs has been a recurring problem in the past few years —with one of the most nagging and notorious being the iPath Dow Jones-UBS Natural Gas Total Return ETN (GAZ). As IndexUniverse Director of Research Dave Nadig sees it, GAZ is basically broken.
GAZ has been trading at a sometimes-hefty premium—divorced partially from the predominantly bearish tone in gas markets—since Barclays, its backer, shut creations in the fall of 2009.
So, between the lawsuit involving TVIX and the nagging recurrence of creations shutdown, FINRA decided the time to act was now.
“Recent events involving exchange-traded notes (ETNs) have placed a spotlight on the market for these products and highlighted the importance of understanding what ETNs are and how they work before you consider investing in them,” the FINRA warning began.
The factors FINRA drew attention to in its note and the reasons why are as follows:
Credit risk – meaning investors could lose all their money if the issuer defaults
Market risk – with the regulator saying investors need to understand the index a given ETN is tracking to avoid surprises along the way
Liquidity risk – with FINRA saying there’s no guarantee a deep trading market will develop around a given ETN, meaning the market could completely dry up when an investor wants to sell
Price-tracking risk – while ETN prices typically track their NAVs, sometime this is not the case, so investors need to take measure of this possibility before buying
Holding-period risk – many ETNs are leveraged, and the returns of such securities can vary dramatically from their underlying indexes, particularly in a trendless market
Call, early redemption and “acceleration” risk – some ETNs can be callable at the issuer’s discretion, and investors need to be aware of these possibilities, particularly since a given ETN could be called when its price is less than what the investor paid for it
Conflicts of interest – sometimes an issuer may be engaging in trading activities, such as shorting, that aren’t consistent with an investor’s risk appetite, and FINRA recommended searching an ETN’s prospectus for “conflicts of interest” to assess possible risks
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