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Regulator warns to avoid ‘unpleasant’ ETN surprises

by Emma Dunkley on Jul 12, 2012 at 12:55

Regulator warns to avoid ‘unpleasant’ ETN surprises

A US regulator has sounded an alert to investors warning them to ‘avoid unpleasant surprises’ in exchange traded notes (ETNs).

The Financial Industry Regulatory Authority (Finra) has issued the note to make investors aware that ETNs do not buy or hold assets to replicate the performance of the underlying index.

ETNs are a form of unsecured debt that trades on exchange with the promise of a return linked to a market index or other benchmark.

As such, they are not funds with ring-fenced assets, leaving the investor exposure to the counterparty risk of the bank issuing the note.

Many investors tend to conflate ETNs with ETFs, even though the two investments have very different risk profiles.

Gerri Walsh, vice president for investor education at Finra, said: ‘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.’

The warning comes after the recent VelocityShares debacle, which saw the ETNs increase in price when Credit Suisse, the issuer, announced it was temporarily halting further issuance of the ETN due to internal limits. Shortly after when issuance resumed, the price dropped.

Aside from this incident, there are intrinsic product risks investors need to take into account. As well as credit risk, there is liquidity risk and market risk, whereby a trading market may not develop and falls in markets can result in losses.

Finra also states price-tracking risk, whereby investors may purchase at a price that varies from closing and intraday indicative values.

However, ETN issuers have argued one of the benefits of these investments over ETFs is that they can eliminate tracking error, although the investor is taking on the credit risk.

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