While the popularity of exchange traded notes (“ETNs”) has surged, ETNs can be extremely volatile, and investors run the risk of losing their entire investment. ETNs reportedly hold $17.4 billion in assets, up from under $5 billion five years ago.
Exchange traded notes issued by Credit Suisse have recently traded at prices that were far above and below the true value of the ETN (See “2 ETNs’ manic swings point out peril of use,” by Jason Kephart, InvestmentNews). The true value of an exchange traded note (or any fund) is the net value of the tracked (or held) index or other asset. But when an asset gets hot, like ETNs, it can get overbought, and when something happens to dry up demand, it can get oversold. All of this can happen fast enough to make your head spin.
In the case of the Credit Suisse, investors apparently were not warned about, and did not notice or consider the fact that the price per share of the ETNs had risen to values that were far higher than the index they tracked. The dramatic run-up in price occurred when the issuing banks announced they would stop issuing shares of the much-desired ETNs (i.e., when it appeared that supply would dwindle, investor demand spiked and so did the price per share ultimately reaching a huge premium over the value of the index). Then the bank reversed itself and announced it would issue more shares of the ETNs. Demand plummeted and so did the price per share. Investors got whipsawed and lost their shirts.
Exchange traded notes are bank-issued promissory notes (IOUs) that track an index. They differ from exchange traded funds (ETFs) in that ETNs do not actually own or hold the index they track. They are simply notes in which the bank promises to pay the return of an index minus fees. The promise is simply an unsecured debt of the issuing bank. If the bank goes bankrupt, as Lehman Brothers did, the holders of its debt are left with nothing but claims against the bankruptcy estate, which may be worth little or nothing. Thus, ETN investors can lose their entire investment.
The Financial Industry Regulatory Authority Inc. (FINRA), the Securities and Exchange Commission (SEC) and Massachusetts’ Securities Division are reportedly investigating the ETN debacle. Charles Schwab & Co. Inc. is said to be considering whether to require that investors be given more specific warnings about the risks of exchange traded notes.
Samuel Lee, an analyst at Morningstar Inc., commented: “It’s kind of ridiculous that some of these products are actually out there, with the things they have hidden in the fine print.”
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