U.S. brokerage regulator warns of ‘unpleasant surprises’ on ETNs

July 11, 2012

By Stuart Gittleman

NEW YORK, July 11 (Thomson Reuters Accelus) – The Financial Industry Regulatory Authority, the U.S. brokerage regulator, warned investors Tuesday in an alert of the features and risks of exchange-traded notes.

The alert, Exchange-traded notes: avoid unpleasant surprises, listed the risks of certain ETNs and urged investors to carefully investigate before investing in them. FINRA and the Securities and Exchange Commission have raised their oversight of disclosures and sales practices for ETNs and other complex structured products, and FINRA enforcement chief Brad Bennett said cases will be brought over suitability.

FINRA also issued Regulatory Notice 12-03 to provide broker-dealers with guidance on supervising the sale of complex products with features that may make it difficult for a retail investor to understand the product’s essential characteristics and its risks.

Addressing these concerns should help compliance professionals ensure that their marketing materials are fair and accurate, that registered representatives are properly trained to sell ETNs and that supervisors are able to determine that the sales are suitable.

The FINRA alert noted that ETNS may not have much performance history, their indexes and investment strategies can be quite sophisticated, their returns can be volatile, and the price computed by the ETN’s issuer can vary 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,” said Gerri Walsh, FINRA vice president for investor education.

The alert described the specific risks associated with certain ETNs, including:

  • credit risk – that ETNs are unsecured debt obligations of the issuer;
  • market risk – that the value of the ETN can change as its benchmark index’s value changes with market forces, which can result in a loss of principal to investors;
  • liquidity risk – that while ETNs are exchange-traded, a trading market for a particular issue may not develop;
  • price-tracking risk – that investors should be wary of buying at a price that varies significantly from closing and intraday indicative values for the ETN;
  • holding-period risk – that some leveraged, inverse and inverse leveraged ETNs are designed to be short-term trading tools, and their performance over long periods can differ significantly from the stated multiple of the performance, or inverse of the performance, as the case may be, of the underlying benchmark during the same period;
  • call, early redemption and acceleration risk – that some ETNs are callable at the issuer’s discretion; and
  • conflicts of interest, because the issuer may engage in trading activities such as shorting strategies that are at odds with investors who hold the notes.

FINRA urged investors to get answers to the following questions before deciding whether to invest:

  • Who is the issuer, and what is its credit rating and financial situation?
  • What index or benchmark does the ETN track, and if it is an unfamiliar market or asset class, is there enough information available to adequately assess the risks?
  • Is the ETN callable by the issuer?
  • Does the ETN offer leveraged or inverse exposure to the underlying benchmark, and, if so, how frequently does it “reset”? ETN names that include “daily” and “short-term” may indicate that the product resets daily and is not intended to be held for long.
  • What fees and costs are associated with the ETN, including the investor fee charged in connection with redemptions?
  • What are the tax consequences, which can vary depending on the nature of the ETN?

FINRA reminded investors that ETNs 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.

FINRA urged investors to read the prospectus and ask their investment professional to clearly explain any fees and expenses associated with a given ETN, and to check with their tax advisor about the tax implications of a particular investment.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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The sorts of problems encountered by ETNs like TVIX, GAZ, and AMJ made headlines but most media coverage did not fully articulate the underlying issues. The FINRA notice provides more detail as to the actual cause of those trading anomalies and how they could affect other ETNs too.

My colleagues and I have posted a number of publications which provide detailed explanation of the leveraged and inverse ETFs, commodities ETFs and VIX-related ETNs mentioned in the FINRA Investor Alert. Our research papers can be found at http://www.slcg.com/research.php

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