Following FINRA’s changes to the Series 7 Content Outline in late 2011, exchange-traded notes (ETNs) became a topic that is a potential test item students may see on their exam. You can read more about ETNs in our Study Manual, but let’s visit them briefly here.
Essentially, an ETN is an unsecured debt obligation that may be worth much more at maturity than its purchase price depending on the performance of the assets or index to which it is linked. The dealer adjusts the intraday and closing indicative values based on the performance of the linked index. The market price often closely tracks that value, although there may be variations based on supply and demand. Unlike an exchange-traded fund (ETF) that is subject only to market risk, ETNs are subject to both market risk and credit risk. The price of an ETN will also reflect the credit quality of its issuer. As a result, an investor must review the liquidity of any given ETN as well.
Although ETNs must be registered under the Securities Act of 1933, they are not classified as investment companies. They are structured products that contain a debt obligation of the issuer that is linked to an index that represents a basket of stocks, bonds, commodities, interest rates, volatility, master limited partnerships, private equity, or metals. Derivative contracts are employed to provide the linked returns. An investor’s return is based on the performance of the underlying index, and ETNs are not principal-protected. If returns on the index are meager or nonexistent and fees outweigh appreciation, it is possible for the investor to experience a negative rate of return.
As with ETFs, ETNs can be leveraged or nonleveraged, inverse and noninverse. Those that are nonleveraged mirror the performance of the linked index. Those that are leveraged can return two or three times the return of the linked index. The values of inverse ETNs and inverse leveraged ETNs move in the opposite direction of the linked index. Similar to leveraged and inverse leveraged ETFs, leveraged ETNs are rebalanced daily or monthly and are best suited for short-term trading and not buy-and-hold strategies. They are not suitable for long-term investors because the daily or monthly rebalancing of leverage could result in the leveraged compounding of losses.
ETNs can experience large price swings when issuers increase or decrease the creation of notes. For example, if an issuer stops creating a popular ETN, demand may outstrip supply, causing prices to rise. When the issuer begins creating notes again, supply will increase, causing the ETN’s price to decline. Investors who bought the ETN at its elevated price may experience a loss if they need to liquidate their holdings at the subsequent depressed prices.
Unlike ETFs, ETNs can be called at the discretion of the issuer. If an issuer finds that a particular issue or group of issues lacks investor interest, the issuer might call the ETN. Investors receive the ETN’s indicative value, based on the performance of the linked index less fees. This may result in a gain or a loss depending on the ETN’s purchase price.
While FINRA does not state how many questions may appear on a given topic, we believe that you should be prepared to answer a small number of questions about ETNs.
Thanks for spending time with us. We hope you found it worthwhile.
—Securities Training Corporation