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Exchange-traded notes (ETNs) have been grabbing headlines recently, as CNN Money reported on how they’re less investor-friendly than other possibilities. As a result, FINRA wants to make sure that investors are aware of the differences between them and other, perhaps more traditional, investments—lest they be taken unaware and get in over their heads. To that end, it has issued an investor alert to educate people about their benefits and pitfalls.
While ETNs are unsecured debt obligations of the issuer—typically a bank or another financial institution—they are different from traditional bonds in a number of ways. This week AdvisorOne takes a look at what you should know before you buy ETNs; in the next slideshow we’ll explore some risks to avoid once you’ve bought them.
1. Who’s Your Daddy—er, Issuer?
Once you know who’s issuing the ETN, be sure to check out the ETN issuer’s credit rating and financial situation. If the issuer is publicly traded, use the SEC's EDGAR database. Remember, ETNs are not registered investment companies and therefore are not subject to the same registration, disclosure and other regulatory requirements as most ETFs or mutual funds. If daddy’s pockets are empty, yours may be soon too.
2. Returns Relative to What?
You might expect that an ETN would correlate to the S&P 500 or some other equally well-known benchmark, but that’s not necessarily the case. If the ETN you’re considering involves tracking the index or benchmark of an unfamiliar market or asset class, make sure you educate yourself sufficiently to be able to know the market or asset and to understand the risks.
3. When Your ETN Says, “Call Me, Maybe”
If the issuer can call the ETN, you’ll find this information in the prospectus—or a financial professional can provide it. Otherwise, you may want to say, “Don’t call me; I’ll call you”—and then not bother.
4. Returns With a Factor of Two—or Ten—That Start From Zero All Over Again
You’ll want to know whether the ETN offers leveraged or inverse exposure to the underlying index or benchmark, and if so, how frequently it "resets." ETNs can say they will provide twice the returns, or more, of the indexes they track.
But even that may not provide a clue to what you could make. Check out the name of the ETN for telltale indications. If you’re looking for a long-term investment, beware of such words as “short-term” or “daily”—they’re a dead giveaway that frequent resetting makes the timeframe of that particular investment unsuitable for your needs, because they’re basically starting all over again each day or month.
5. How Much Is That Doggie in the Window? (Including License and Fees)
The cost of the investment itself may turn out not to be worth your while if fees and other costs are too high. The range of fees, including the investor fee charged at redemption, can vary greatly from one ETN to another. Make sure you know how many fees there are and how much they will be—either from the prospectus or from asking someone in the know. Otherwise, you could end up with a mutt in a basket instead of a blue-ribbon winner at Westminster.
6. The Tax Man Cometh (and Taketh Away)
Fees aren’t the only cost associated with ETNs; their tax treatment can also vary, depending on the nature of the ETN. If in doubt, check with a tax advisor to see whether a given ETN will end up costing you more at tax time than it’s worth. Otherwise, you and the IRS could end up getting pretty cozy.
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