The Financial Industry Regulatory Authority (FINRA), the self-regulatory arm of the U.S. securities brokerage industry, has issued an Investor Alert regarding the features and risks of exchange-traded notes (“U.S. brokerage regulator warns of ‘unpleasant surprises’ on ETNs,” by Stuart Gittleman, Reuters).
FINRA and the Securities and Exchange Commission have raised concerns about disclosures and sales practices involving exchange-traded notes, as well as other complex structured products. FINRA enforcement chief Brad Bennett reportedly said that FINRA will bring enforcement actions against firms for unsuitable recommendations of exchange-traded notes.
Earlier this year, FINRA issued Regulatory Notice 12-03 to provide broker-dealers with guidance on supervising the sale of complex products that are difficult for a retail investors and brokers to understand. Firms are required to ensure that their marketing materials are fair and include accurate disclosures of all material risks; that registered representatives are properly trained to understand the risks of exchange-traded notes; and that supervisors are able to determine whether or not the sales meet suitability requirements.
The FINRA alert warns that exchange-traded notes often have little or no performance history, their indexes and investment strategies can be quite complex, their returns can be volatile, and the price computed by the issuer can vary significantly from the price in the secondary market.
“ETNs are complex products and can carry a raft of risks. 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,” Gerri Walsh, FINRA vice president for investor education, was quoted as saying.
Exchange-traded notes present the following risks, among others:
(i) Exchange-traded notes are unsecured debt obligations of the issuer;
(ii) The value of an exchange-traded note is linked to the performance of a reference asset, which can result in a loss of principal to investors;
(iii) Exchange-traded notes are often illiquid because there is often no secondary market;
(iv) The price may vary significantly from closing and intraday indicative values;
(v) Some leveraged, inverse and inverse leveraged exchange-traded notes are designed for short-term or day trading, and the performance over a longer may deviate markedly from the underlying benchmark;
(vi) Some exchange-traded notes are callable at the issuer’s discretion; and
(vii) The issuer may engage in trading activities such as shorting strategies that conflict with the interests of investors who hold the notes.
Before deciding whether to invest, investors and their advisers should, at a minimum, know:
(i) The identity, credit rating and financial outlook of the issuer
(ii) The index or benchmark linked to the ETN, and if it is an unfamiliar market or asset class, whether there is sufficient information to properly assess the risks
(iii) Whether the exchange-traded note is callable
(iv) Whether the exchange-traded notes is leveraged
(v) Whether the exchange-traded notes is inverse to the underlying benchmark, and, if so, how frequently it “resets” (product names that include “daily” and “short-term” may indicate that the product resets daily and is not intended to be held for a longer period)
(vi) The fees and costs of the exchange-traded note, including the investor fee charged in connection with redemptions, and
(vii) The tax consequences, which vary depending on the type of the exchange-traded note.
Exchange-traded notes are not issued by registered investment companies and are not subject to the same registration, disclosure and other regulatory requirements as most mutual funds or exchange traded funds.
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.