An ETN, or exchange-traded note, offers access to complex investment tools, but buyers beware.
The growing ETN market offers investors access to exotic financial instruments, but experts warn that the sophisticated products might not be appropriate for the average guy who often confuses the product with its even more popular cousin, the ETF.
So far, investors have put $16 billion into U.S.-listed ETNs, reports ETF guide. The website explains, “While ETNs and exchange-traded funds (ETFs) are sometimes grouped together, or worse, confused as the same thing, they are not.”
An ETN, or exchange-traded-note, differs significantly from an ETF, particularly in the level of risk it poses. An ETN is a debt product enabling a financial institution to borrow money from investors. In exchange, the firm promises a return linked to the performance of an index or other pre-determined asset, less fees. The ability to pay upon the maturity of the note depends on the financial strength of the firm issuing the debt, so investors take on the credit risk of the issuer when they buy an ETN. That credit risk became painfully clear to investors who bought ETNs issued by Lehman Brothers, a casualty of the 2008 market meltdown, when the securities eventually become worthless.
An ETF can track a variety of markets, such as a volatility index, or can be used as a day-trading tool to gain a leveraged exposure to an asset. According to ETF guide, many U.S.-listed ETNs are composed of products issued by European banks caught up in sovereign debt crises across the continent.
The Swiss bank UBS, this week rocked by a trading scandal resulting in $2 billion in losses, offers an ETN product linked to market volatility. Return is based on the daily performance of the S&P 500 VIX Futures Index Series. These ETNs are not appropriate for most investors, warns UBS in its shareholder information. “Each series of the ETNs is designed as a trading vehicle for sophisticated investors,” says UBS. “The ETNs are not intended to be a ‘buy and hold’ investment.”
The UBS ETN series provide investors exposure to futures contracts on the CBOE Volatility Index or VIX, but the product involves risk, the bank says. ETN investors are at risk of losing some or all of their investment because the notes have no downside protection when the VIX declines.