Exchange Traded Notes (ETNs) Frequent Asked Questions – Boca Raton, Florida FINRA Arbitration and State and Federal Court Litigation Attorney:
Frequently asked questions about Exchange Traded Notes (ETNs). ETNs are unsecured debt obligations of financial institutions that trade on a securities exchange. ETN payment terms are linked to the performance of a reference index or benchmark, representing the ETN’s investment objective. You should understand that ETNs are complex and involve many risks for interested investors, and can result in the loss of your entire investment.
What is an ETN?
ETNs are unsecured debt obligations of financial institutions. They are very different from traditional corporate bonds because, unlike traditional corporate bonds – which pay a stated rate of interest – the return on an ETN is based on the performance of a reference index or benchmark (minus any investor fees you may pay). ETNs generally do not pay interest to their holders. Payments on ETNs may be linked to well-known broad based securities indexes or based on indexes tied to emerging markets, commodities, volatility, a specific industry sector (e.g. oil and gas pipelines), foreign currencies, or other assets. ETNs that offer leveraged exposure pay a multiple of the performance of the reference index or benchmark. Other ETNs (called inverse ETNs) are calculated based on the opposite of the performance of the reference index or benchmark. Many ETNs are issued with maturities of 20 or 30 years, and are not intended to be held to maturity. Accordingly, returns to an investor generally arise from trading the ETN rather than from holding the ETN to maturity.
What is the Difference Between an ETN and an ETF?
ETNs are often confused with exchange-traded funds (ETFs). ETNs and ETFs are both traded on a securities exchange and can be bought and sold throughout the day, but there are important differences. ETFs are registered investment companies. An investor in an ETF owns shares of a fund, which represents an ownership interest in an underlying portfolio of assets. An ETF discloses to investors the value of its portfolio of assets by publishing an end-of-day net asset value and by disseminating an estimate of its value generally every 15 seconds during the trading day, which is sometimes called an intraday indicative value. An ETF issues and redeems its shares in creation units, at their net asset value.
ETNs share some characteristics with ETFs. For example, ETNs also issue and redeem notes in creation unit sizes (generally, 25,000 to 50,000 notes); like with ETFs, the creation and redemption process affects the number of notes trading at any point in time. For both ETNs and ETFs, the purchasers of the creation units split them up to sell the individual notes or shares, as applicable, to investors in transactions on an exchange. But there is a fundamental difference between ETFs and ETNs. Unlike ETFs, ETNs do not own an underlying portfolio of assets and this makes holders of ETNs subject to the creditworthiness of the issuer. As ETNs do not own assets, when issuing new ETNs, ETN issuers calculate the value of the ETN using a described formula, rather than using net asset value.
Market Trading and Valuing ETNs
ETNs are listed on an exchange and may be bought and sold at market prices. An ETN’s prospectus will describe both how the value of the note is determined on any particular trading day, as well as how the value of the reference index or benchmark is calculated. Issuers publish a value at the conclusion of each trading day representing the amount an issuer would be obligated to pay the investor. Market prices may vary from these published values.
Potential Risks to Consider Before Investing in ETNs
Potential risks of investing in ETNs include the following:
Complexity – You and your broker should take time to understand the manner in which the reference index or benchmark is calculated, including the fees that are included in either the reference index or the calculation of the value of the ETN. Compare and contrast the ETN to other investment products offering a similar investment strategy.
Credit Risk (Issuer Default) – You should be aware that when you purchase an ETN you are subject to the creditworthiness of the issuing financial institution and would be a creditor if the issuer defaults on payments due.
Market Risk – In addition to the credit risk of the issuer, ETNs also expose investors to the performance risk of the reference index or benchmark.
Leverage – Leveraged, inverse, or inverse-leveraged ETNs reset on a daily basis their exposure to the leveraged, inverse, or inverse-leveraged exposure stated in the prospectus, meaning that all investors receive an equal amount of leveraged, inverse, or inverse-leveraged exposure. As a result, investors holding such ETNs for more than one day should not expect to receive returns proportional to the exposure stated in the prospectus. The difference can be significant. Consequently, leveraged, inverse, or inverse-leveraged ETNs are not typically used as buy-and-hold instruments.
Price Volatility (Market Price versus Indicative Value) – ETNs can trade at premiums or discounts to their indicative value, especially in instances in which the issuer has suspended further note issuances. If you are considering purchasing ETNs, you should compare market prices against indicative values.
Liquidity Risk – There is a risk that if you need to cash out your investment, you may not be able to sell the ETN immediately and at a price that you would consider reasonable (for example, you may have to sell the ETN at a lower price than if you were able to wait to liquidate your investment). This is the case for most illiquid securities and the liquidity of ETNs varies significantly. For example, some ETNs have daily volume in excess of a million notes, while others may have little trading activity over several days. You should consider your overall timeframe for the investment, including how quickly you may need to sell the ETN.
Do not invest in something that you do not understand. Before purchasing an ETN, you should consider:
- Whether ETNs are a suitable investment for you. You should review your investment objectives and tolerance for risk with your broker or financial adviser before you consider investing in an ETN. They can help you determine whether or not the risks associated with a particular ETN are within your tolerance for risk, or whether your investment needs are better served by investing in another product. Your broker should only recommend transactions and investment strategies that are suitable for you based on your investment profile.
- What fees are associated with an ETN, such as fees included in the reference index or benchmark, daily investor fees that reduce the closing indicative value of the ETN, and the amount of brokerage commissions you may pay when buying and selling an ETN.
- Whether you understand how the reference index or benchmark is calculated.
- Whether you understand how the indicative values and redemption values are calculated and what they measure.
- Whether you understand the tax implications, if any, because the tax treatment can vary depending upon the nature of the ETN. It may be appropriate to consult a tax professional.
Finally, you may wish to consider seeking the advice of an investment professional. If you do, be sure to work with someone who understands your investment objectives and tolerance for risk. Your investment professional should understand complex products, such as ETNs, and be able to explain to your satisfaction whether or how they fit with your objectives.
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