Exchange-Traded Funds (ETFs) are investment products designed to replicate the returns of an index (e.g., the S&P 500, Dow Jones Industrial Average, or the VIX) or commodities (e.g., gold, silver or crude oil) while trading on exchanges like stocks so, unlike mutual funds, they may be bought and sold at a market value throughout the trading day. Similar to a mutual fund, an ETF holds assets such as stocks, bonds, or commodities.
Exchange-Traded Notes (ETNs) are unsecured bank-issued debt securities (“notes”), also traded on exchanges, that are typically designed to track the performance of a described market benchmark or strategy. Because they are unsecured, they expose buyers to the credit risk of the issuing bank, in addition to the market risk of the ETN’s underlying benchmark or strategy. Unlike an ETF or mutual fund, the ETN does not hold any assets — it is simply a promise by the bank to pay the holder an amount defined by the ETN.
If you do not understand how an ETF or ETN works or the risks associated with them, they are likely not right for you.
The ETF/ETN Industry has Grown Considerably, but has also Come Under Significant Scrutiny
As the Financial Times recently reported, exchange-traded products have exploded into a $1.8 trillion industry. Banks are being criticized, however, for using ETNs to offset internal risks, passing the risks onto investors – “recycling risk.” Essentially, banks can use ETNs to hedge their own internal positions with outside investors who purchase the ETNs as the (sometimes unknowing) counterparties. Another criticism of the products is lack of transparency, leaving the average investor with little knowledge about how the investments work or what is behind them.
While ETFs are subject to certain regulatory limitations in the way they are structured, ETNs have less stringent regulatory requirements. Neither have the highly regulated structure of mutual funds, which are more easily understood by the average investor.
ETN TVIX Drops 30% in One Day
In February 2012, Credit Suisse suspended the creation of new units of TVIX, an ETN intended to return twice the daily performance of the S&P 500 VIX Short-Term Futures Index (“VIX” refers to the Chicago Board Options Exchange Volatility Index, a benchmark that measures volatility of the S&P 500 Index). The continued demand for TVIX combined with limited supply (due to the suspension) caused the ETN to trade at a premium above its indicative value. This trend continued until March 22, 2012, when TVIX suddenly dropped 29%. Fundamental market conditions in VIX futures did not explain this substantial drop.
At approximately 7:30 p.m. on March 22 (after trading closed), Credit Suisse issued a Press Release disclosing it would resume issuing TVIX ETNs. Credit Suisse’s decision would be expected to reduce or even eliminate the product’s market premium by increasing the supply. The timing of Credit Suisse’s press release — mere hours after the 29% crash — led commentators to speculate whether the TVIX collapse was caused by the leak of Credit Suisse’s decision, enabling some investors to sell their positions ahead of the public news and contributing to the crash.
The Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) are looking further into the TVIX collapse. Moulton & Arney is investigating potential claims on behalf of clients who lost money in the TVIX investment.
FINRA Investigation into Brokers Recommending and Selling Certain ETFs
FINRA’s Chief of Enforcement recently announced FINRA will bring enforcement actions against some brokerage firms for recommending and selling leveraged and inverse ETFs that were not suitable for their customers. The claims may also allege the firms’ financial advisors who sold the ETFs received inadequate training in the securities. See Reuters Article for more information.
While these ETFs may be appropriate for professional traders, they may not be suitable for long-term retail investors. FINRA is concerned that brokers are selling these products to retail investors who are holding them for long periods of time, when there are risks to holding them for more than a day. FINRA’s stated focus is for brokerage firms to understand what they should do to make sure their brokers are trained properly and sell the products to appropriate customers.
Others have voiced concerns about the ease with which individual investors can buy ETFs and ETNs and have suggested regulators make it more difficult for them to do so by requiring risk acknowledgments to be signed in advance of investing.
FINRA Sanctions Citi, Morgan Stanley, UBS, and Wells Fargo Advisors
Earlier this month, FINRA announced that it had sanctioned four major Wall Street firms — Citigroup Global Markets, Morgan Stanley, UBS, and Wells Fargo Advisors — more than $9 million for selling leveraged and inverse ETFs without reasonable supervision and without a reasonable basis for recommending the investments. The amount includes $1.8 million in restitution to customers. Among other things, FINRA found that the firms “failed to conduct adequate due diligence regarding the risks and features of the ETFs” and that leveraged and inverse ETFs were improperly sold to customers with conservative investment objectives or risk profiles. See the FINRA News Release for more information.
About Moulton & Arney, LLP
Moulton & Arney is a boutique litigation and arbitration firm founded on a genuine commitment to providing superior, personalized representation. We are at our best handling complex cases that require ingenuity and experience. Our focus is on understanding each client’s needs, providing clear direction and achieving RESULTS efficiently and effectively.
Attorney Cynthia R. Levin Moulton, the firm’s founder, has a proven track record in investment fraud claims involving an array of complex investment products. She has been named a Texas Super Lawyer in 2004, 2005, 2007, 2009, 2010, and 2011 a Thomson Reuters Service, is rated 5 out of 5 by Martindale.com, and is rated a 10.0 by AVVO.com.
To contact Moulton & Arney, LLP, visit http://www.moultonarney.com or, call (866) 378-4465, or (713) 353-6699.