Exchange-traded notes are complex products sold by “the best salesmen in the world” who are often betting that their potential customers do not know just how complex they are. In most cases, investors would be better off not buying exchange-traded notes, according to USA Today’s John Waggoner (“Non-experts may want to avoid ETNs”).
An exchange-traded note is essentially an unsecured IOU issued by an investment bank. Unsecured means that it is not backed by any collateral. If the issuer defaults, as Lehman Brothers did, the exchange-traded note (IOU) holder has an unsecured claim against the assets of the issuer ? along with a long line of other claimants.
As the name implies, exchange-traded notes trade on exchanges like exchange-traded funds, but they are very different from exchange-traded funds. Exchange-traded notes are not regulated like mutual funds and some exchange-traded funds are.
Exchange-traded notes track various indices. Those indices have become more and more exotic and concentrated over the course of time. New exchange-traded notes often track new indices with no track record.
The Financial Industry Regulatory Authority (FINRA), the brokerage industry’s self-regulatory organization, recently published a warning to investors about the dangers of exchange-traded notes. “We were concerned that investors hear about these ETNs and mistake them for traditional exchange-traded funds,” Gerri Walsh, vice president for investor education at FINRA, was quoted as saying. He went on to add “There are very significant differences between ETNs and ETFs. Understanding one doesn’t mean understanding them all.”
One of FINRA’s concerns is that investors are often not informed that exchange-traded notes do not pay income like traditional bonds and bond funds do. “We wanted to get ahead of this and inform investors,” Walsh was quoted as saying.
“ETN investors don’t appreciate the fact that they are counter parties to vastly more sophisticated investment banks, whose interests are diametrically opposed to investors’ interests,” Morningstar ETF analyst Samuel Lee was quoted as saying.
FINRA highlights the following risks of investing in exchange-traded notes:
- Liquidity risk. Many smaller, relatively new exchange traded notes that track exotic indices do not have an active market, making them illiquid (hard to sell when you want to).
- Tracking risk. Exchange traded notes can differ significantly from its index. Those that promise double or triple the returns (or losses) of an index, can have even greater variances from the index.
- Call risk. Some exchange-traded notes are callable meaning they can be redeemed by the issuer before their maturity dates. If an exchange=traded note is selling for less than the purchase price when it is called, the investor loses money.
- Conflicts of interest. The issuing bank may be making bets that would pay off for the bank if your exchange-traded note loses money.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.