The rise of exchange-traded products has made it easier than ever for investors to get exposure to a wide array of investments they couldn't buy before. With products covering just about every niche of the financial markets, their trading flexibility and simplicity has made them very appealing to many investors.
But as we've seen in a variety of other contexts, just because something is popular and easy doesn't mean that it's always a smart investment. When the industry's own watchdog points to an investment with a critical eye, it pays to take notice before you get burned.
Exchange-traded notes and you
By now, most people have heard of exchange-traded funds. These vehicles buy stocks or other securities, giving their shareholders a proportional ownership interest in their pools of assets. With ETFs having to disclose their holdings on a daily basis, transparency is a key advantage that investors like about ETFs.
But although their three-letter acronym suggests a close resemblance to ETFs, exchange-traded notes or ETNs are actually a very different animal. Although ETNs typically track passive indexes the same way that most ETFs do, an ETN doesn't have any claim to the stocks or other assets that are part of the index it tracks. Rather, as its name suggests, an ETN is a note -- a debt obligation of the financial company that issues it. For instance, the iPath S&P 500 VIX Short-Term Futures ETN (NYS: VXX) is issued by Barclays, and any payments the ETN makes are unsecured obligations of the bank.
That in itself raises some issues. But it's not the aspect that the Financial Industry Regulatory Authority highlights as the biggest concern for investors.
When FINRA speaks, listen
The troubling attribute of ETNs in FINRA's eyes stems from the potential for big deviations between the price at which ETN shares trade and their "indicative value," or what the notes are actually worth. A recent experience with one ETN, the VelocityShares Daily 2x VIX Short-Term ETN (NYS: TVIX) , provides an extreme example in which the share price on the open market reached nearly twice the ETN's indicative value.
The reason this happens is that the mechanism for creating new ETN shares is different from how the typical exchange-traded fund works. With ETFs, institutions known as authorized participants are allowed to work with the ETF management company to create or redeem large blocks of ETF shares. Because those authorized participants can profit from arbitrage opportunities if the premium or discount to true value becomes too large, their influence tends to keep ETF share prices from straying too far from their real value.
With ETNs, though, it's largely up to the individual note issuer whether to add new shares to the market. In the case of the VelocityShares ETN, Credit Suisse (NYS: CS) stopped issuing new notes temporarily, at which point demand pushed the share price through the roof. When Credit Suisse started issuing new notes a month later, that premium largely disappeared, costing investors who had unwittingly paid far too much for the shares.
More recently, JPMorgan Chase (NYS: JPM) set the stage for a potential repeat of that scenario by choosing not to issue more shares of its JPMorgan Alerian MLP Index ETN (NYS: AMJ) . Currently, the ETN trades at a modest 1.5% premium, but the environment for energy-related companies has been tepid at best recently. If energy perks back up, then much greater premiums could result, potentially creating another bubble waiting to burst.
Know your risks
This price-tracking risk is just one of the things to watch out for with ETNs. FINRA also calls out credit risk from the issuer, possible illiquidity in thinly traded ETNs, call provisions, and potential conflicts of interest as among the things to consider before you invest in ETNs.
ETNs aren't automatically bad investments to consider. But as the level of complexity in exchange-traded products rises, it's more important than ever to make sure you know exactly what you're investing in. Making blind bets can cost you big.
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At the time thisarticle was published Fool contributor Dan Caplinger looks at most warnings -- even the silly ones. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never cries wolf.
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