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Find Out What FINRA's Warning You About

Dan Caplinger
July 11, 2012

The rise of exchange-traded products has made it easier than ever for investors to get exposure to a wide array of investments they couldn't buy before. With products covering just about every niche of the financial markets, their trading flexibility and simplicity has made them very appealing to many investors.

But as we've seen in a variety of other contexts, just because something is popular and easy doesn't mean that it's always a smart investment. When the industry's own watchdog points to an investment with a critical eye, it pays to take notice before you get burned.

Exchange-traded notes and you
By now, most people have heard of exchange-traded funds. These vehicles buy stocks or other securities, giving their shareholders a proportional ownership interest in their pools of assets. With ETFs having to disclose their holdings on a daily basis, transparency is a key advantage that investors like about ETFs.

But although their three-letter acronym suggests a close resemblance to ETFs, exchange-traded notes or ETNs are actually a very different animal. Although ETNs typically track passive indexes the same way that most ETFs do, an ETN doesn't have any claim to the stocks or other assets that are part of the index it tracks. Rather, as its name suggests, an ETN is a note -- a debt obligation of the financial company that issues it. For instance, the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX  ) is issued by Barclays, and any payments the ETN makes are unsecured obligations of the bank.

That in itself raises some issues. But it's not the aspect that the Financial Industry Regulatory Authority highlights as the biggest concern for investors.

When FINRA speaks, listen
The troubling attribute of ETNs in FINRA's eyes stems from the potential for big deviations between the price at which ETN shares trade and their "indicative value," or what the notes are actually worth. A recent experience with one ETN, the VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX  ) , provides an extreme example in which the share price on the open market reached nearly twice the ETN's indicative value.

The reason this happens is that the mechanism for creating new ETN shares is different from how the typical exchange-traded fund works. With ETFs, institutions known as authorized participants are allowed to work with the ETF management company to create or redeem large blocks of ETF shares. Because those authorized participants can p