Exchange Traded Notes (ETN) Risks Highlighted in FINRA Warning

The Financial Industry Regulatory Authority (FINRA) has issued an alert to warn investors about the risks associated with exchange-traded note (ETN) investments. 

The warning highlights the importance of understanding what ETNs are and how they work before individuals consider investing in the instruments.

The alert comes as news of Credit Suisse, the bank behind the VelocityShares Daily 2x VIX Short-Term ETN, faces a class action lawsuit for allegedly failing to properly inform investors about the nuances of the security earlier this year.

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ETNs are unsecured bank debt backed by their issuer’s credit, unlike exchange-traded funds (ETFs), which hold assets. Banks create and redeem shares of ETNs based on the level of demand for the securities. That demand typically doesn’t affect the price, since the ETNs track the performance of an index.

The complaint against Credit Suisse alleges that the company understated the risks associated with exchange-traded notes, such as TVIX, and that the Offering Documents did not fully warn investors of the losses that could occur if Credit Suisse reached the limit of ETNs it could offer and stopped issuing them.

“FINRA is issuing this Alert to inform investors of the features and some particular risks of ETNs—and to suggest questions to ask when considering investing in these products,” the regulator’s warning said. “While the names may sound alike, investors should also understand that ETNs and exchange-traded funds (ETFs) differ in some fundamental and important ways.”

This warning also includes investors in ETFs. These types of funds, unlike ETNs, track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc.

When an investor buys shares of an ETF, they are buying shares of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds, that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market, they try to be the market.

FINRA recommends avoiding the following investor problems when dealing with brokers:

  • Misrepresentation—untrue representations or omissions of material facts relating to the investment.
  • Cold-calling—unsolicited or unwanted phone calls using high-pressure, persistent tactics.
  • Unsuitability—an investment made by a broker that is inconsistent with the investor’s investing objectives and profile.
  • Unauthorized trading—sale or purchase of securities without the investor’s prior knowledge and authorization.

A number of financial fraud lawsuits have been filed by investors against brokers who recommended or sold ETNs, which were unsuitable investments. Such disputes that arise between investors and brokers are typically handled through FINRA arbitration panels.

FINRA is a non-governmental regulatory body that handles the resolution of disputes between investors, stockbrokers and other financial firms. It was created in July 2007 as a successor to the National Association of Securities Dealers, to arbitrate stock broker fraud claims that can include charges of breach of contract, breach of fiduciary duty, negligence, misrepresentation, unauthorized trading and other claims that investments were improperly handled.

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