Exchange-Traded Notes—Avoid Unpleasant Surprises
Exchange-traded notes (ETNs) are a type of debt security that trade on exchanges and promise a return linked to a market index or other benchmark. Like other exchange-traded products (ETPs), ETNs can offer investors convenient and cost-effective exposure to everything from commodities to emerging markets, but they can be complex and carry numerous risks—including the risk that the issuer will default on the note or take other actions that may impact the price of the ETN.
To help avoid unpleasant surprises later, be sure you understand how ETNs are traded, issued and redeemed before you invest.
ETN Trading, Issuance and Redemption
ETNs list on an exchange and can be bought and sold at market prices, similar to other exchange-traded investments. Market prices of ETNs may fluctuate due to movements in the indexes they track, as well as other factors, including ETN issuances and redemption activity.
Issuers of ETNs issue and redeem notes as a means to keep the ETN’s price in line with a calculated value, called the indicative value or closing indicative value for ETNs. This value is calculated and published at the end of each day by the ETN issuer. When an ETN is trading at a premium above the indicative value, issuing more notes to the market can bring the price down. Similarly, if an ETN is trading at a discount, redemption of notes by the issuer reduces the number of notes available in the market, which tends to raise the price.
ETN issuers have primary control over the issuance and redemption processes in the ETN market. The decision to issue additional notes is at the issuer’s sole discretion. Investors may initiate the redemption process prior to an ETN’s maturity date, following precise steps laid out by the issuer in the prospectus. The process generally begins by submitting a "notice of redemption" form to the issuer. Given the various steps in the process, transaction fees—and especially the large number of ETNs required to initiate a redemption (usually 25,000 or 50,000)—redemption is not generally a practical source of liquidity for most retail investors.
If a redemption occurs, the issuer will redeem the notes at the ETN’s indicative value. Indicative values are generally based on the value of the underlying index or benchmark, minus certain fees (sometimes referred to as "daily investor fees"), which vary across ETNs and can fluctuate for a given ETN. ETNs also typically have an intraday indicative value that is calculated and published every 15 seconds during the trading day under the applicable trading symbol by the market in which the ETN trades. Each ETN uses its own formula for computing its indicative value, which is generally outlined in the ETN’s prospectus or pricing supplement.
Be Alert to Significant Deviations
An ETN’s closing indicative value, as well as its intraday indicative value, are distinct from an ETN’s market price, which is the price at which an ETN trades in the secondary market. In theory, an ETN’s market price should closely track its closing and intraday indicative values. However, an ETN’s market price can deviate, sometimes significantly, from its indicative value.
Price deviations can happen for a variety of reasons. For example, an ETN might trade at a premium to its indicative value if the issuer suspends issuance of new notes. Paying a premium relative to the indicative value to purchase the ETN in the secondary market—and then selling the ETN when the market price no longer reflects the premium—can lead to significant losses for an investor.
Consider, for example, a scenario in which an ETN experienced price movement that diverged significantly from its indicative value and the performance of the index it tracks, due in part to suspensions in the issuance of new notes. This caused the ETN to trade at a significant premium—nearly 90 percent. When the issuer of the ETN resumed the issuance of new notes, the market price of the ETN fell sharply—dropping by more than half in two days.
For this reason, before trading in the secondary market, it’s a good idea to compare an ETN’s closing and intraday indicative values with the market price. If the ETN is trading at a significant premium to its closing or intraday indicative value, you might want to consider similar products that are not trading at a premium, or that provide similar expose to the index or asset class.
It’s also a good idea to determine whether the issuer has suspended issuing new notes, and if so, why. Find out from your investment professional or brokerage firm what types of orders you may place for the ETN and what will happen if it is no longer listed on an exchange.
As with all investments, only invest if you’re confident that ETNs can help you meet your investment objectives and you’re knowledgeable and comfortable with the risks associated with the investment.
Learn more about ETNs and other exchange-traded products to assess whether they’re right for you.
