Earlier this month we took a look at FINRA's 6 Critical Tips Before Buying ETNs—unsecured debt obligations of the issuer, such as a bank or other financial institution.
The Financial Industry Regulatory Authority wants to make sure that investors are aware of the differences between exchange-traded notes 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.
This week we’re checking out, courtesy of that investor alert, some specific risks investors should beware of if they’ve done at least some homework and decided to invest in ETNs anyway.
1. Risky Business: Credit Risk
Have another look at that definition of an ETN—it’s an unsecured debt obligation. So if the issuer defaults, the investment goes bust. If you’re going to sink money into one of these, make sure you can afford to lose it—all of it.
The value of an ETN is tied to its index. If the market becomes disillusioned with that index, the ETN’s value can plummet and take the investor’s principal with it—putting the investor in the hole in more ways than if she just put her money into an investment only subject to credit risk.
Another factor to consider is what the index being tracked by the ETN is measuring. Is it a dynamic trading strategy? A futures market? And does it reflect total returns, or some other criterion?
Be wary if you have to keep investment funds liquid. An ETN can tie up funds if a trading market fails to develop. Not only that, but there are times when an issuer can simply delist an ETN—in which case, nobody will be buying or selling anything. Including you.
While ETNs usually trade at prices that closely track their indicative values, this is not necessarily always true. If you’re shopping on the secondary market, make sure to check market prices against indicative values. If a price is significantly at odds with closing and intraday indicative values, be cautious.
5. Slow Down, Tiger!: Holding-Period Risk
Some ETNs, in particular some leveraged, inverse and inverse leveraged ETNs, are designed to be short-term trading tools instead of buy-and-hold investments; these can have holding periods as short as a single day.
When you take compounding into effect—something that works marvelously on buy-and-hold investments if they rise over the long term—short-term ETNs can confound investors over long periods because they will not exhibit the stated multiple of performance (or inverse of the performance) as the underlying index or benchmark over the same period.
Some ETNs, says FINRA, are callable at the issuer's discretion. In some instances ETNs can be subject to early redemption or an "accelerated" maturity date at the discretion of the issuer or one of its affiliates. Since those ETNs can be called at any time, when the call does come, their value may be lower than what you paid when you bought them—or, worse yet, zero—meaning a partial or total loss of your investment.
You may find that there are numerous possible conflicts of interest between your own goals and those of the issuer of an ETN. For example, the issuer of the notes may be engaged in shorting while you’re holding on to your investment—something that will not make you happy. Make sure you comb through the prospectus to find any mentions of "conflicts of interest," and then carefully consider whether these conflicts are worth the risk.
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