Exchange Traded Notes (ETNs): Avoid Unpleasant Surprises

Structured products were popular during the rapid growth of the Russian market from 2005 to 2007. In 2008, during the crisis caused by the collapse of the global derivatives market, investors fled for safety by selling stocks and bonds, and forgot about buying complex instruments for a long time. Now, according to Vladimir Potapov, head of portfolio investments at VTB Capital Investment Management, the demand for structured products is growing again. Anton Plyasunov, head of the derivatives products development department of the FG BCS, estimates this market at 0.5% of the volume of bank deposits, or 67 billion rubles.

What is an ETN?

An exchange-traded note, or ETN, is an unsecured and unsubordinated debt obligation issued by a bank or other financial company. Despite its debt nature, this security is significantly different in its properties from a regular bond. In the United States, exchange-traded notes generally do not pay coupons. Instead, upon maturity of the note, the issuer agrees to pay the holder a premium tied to a specific benchmark, less a fee. In Russia, existing notes provide coupon income. Just like on bonds, the accrued coupon income (accumulated coupon income) is paid.

Like a stock or exchange-traded fund (ETF), an ETN is traded on an exchange. Know can be purchased through a broker. But unlike an ETF, the note issuer is not required to purchase and hold any assets to track (replicate) the price of the index. This feature of ETNs is their main difference. An exchange-traded note is an obligation unsecured by assets, while a mutual fund or ETF provides for the mandatory purchase of real assets.

The ideal situation is when the note is issued by a reliable organization with a high international credit rating. But in a real situation, the “reliability” and creditworthiness of a significant number of issuers is often more difficult to understand than the note itself. In addition, organizations that were quite creditworthy just recently may not be so in a few years... Such changes occur especially quickly during financial crises.

Some ETNs follow popular stock or bond indices, while others follow much more exotic assets. For example, there are ETNs that follow stock indices of emerging markets, gold, oil, various currencies and... market volatility. Some of the indices followed by exchange-traded notes are quite complex in nature and do not have significant history to verify past performance. Income usually depends on the change in the price of the note, if not held until maturity, interim payments (in Russia), or the payment (if any) upon redemption of the note. In this respect, the essence of the note is reminiscent of “structured products”, which banks have been actively promoting lately, and therefore in Russia notes are often called structured (or structured) notes. A structured note is not always exchange-traded (i.e., it is not always traded on an exchange).

Structural notes as an honest way to take money from the population

Summary: You should not trust promises of guaranteed high returns. If you don't understand where it comes from, chances are there is no guaranteed return.

Recently, several clients approached me with a request to comment on structured notes purchased from our investment companies and state banks. The client's current losses on these notes range from 30% to 70% of capital. For those who have not yet set foot in this territory and wisely choose to learn the nuances through the experience of other people, the material below may be useful.
You may save time, money and nerves. I will analyze a structured note with an auto call on a basket of shares with partial (conditional) protection, popular in investment companies and VIP branches of our banks. This is an actual note taken from an investor's portfolio. This note is popular for reasons that I will discuss a little later, in the section on the disadvantages of notes. First you need to figure out what it is and how it works.

Note example

The underlying asset is 4 shares: Biogen Western Digital Micron Technology Discovery Inc

Currency: USD Coupon: 10% Security barrier: downside protection up to 35% Note term: 3 years Autocall conditions: in any quarter if the price of all four securities is higher than the placement price Minimum investment amount: $100,000 Issuing bank: Societe Generale (France)

By the way, if you did not understand anything from the name and description of the conditions, this means that note sellers have an information advantage over you and will present the note in a way that is beneficial to them.

How the note works 1) The note is valid for 3 years, or 12 quarters. At the end of each quarter, you receive a coupon (at the rate of 10% per annum, that is, 2.5% of the money invested each quarter), but only if each of the 4 shares trades in the range of 65% or more of the price that was indicated upon placement. In other words, if each of the securities did not fall by more than 35% of the offering price. Conventionally, it cost $100 on the date of purchase of the note, now it costs $65 or more. Difficult? This is the simplest one so far.

2) If at least one of the 4 securities fell by more than 35%, you do not receive a coupon, but the coupon is remembered. This means that if at the end of the next quarter the “bad” promotion recovers, you receive both the next coupon and the coupon that was not paid before (the “memory” effect - you remembered the coupon and paid later). If at least one of the securities fell below the protective barrier of 35% and did not recover, you ultimately do not receive coupons.

3) If in a certain quarter all four shares rose above 100% of the price at the time the note was created, then the note is redeemed early (“autocall”), and you thus stop receiving income, i.e. you get back the $100,00 you invested and the coupon you earned at the rate of 10%, or $2500.

4) If the shares included in the note somehow grew, fell, or generally changed in price during the period, but there was no auto-call situation, the note survives to maturity. And then 2 scenarios are possible: either you get back the invested amount, along with the last coupon, or (attention!) the worst of the shares, which sank more than others, if it sank by more than 35%. That is, you invested $1,000, some share like Western Digital fell by 2 times over these 3 years, and you are happy to receive this share instead of $1,000 face value, albeit at the price that was at the time the note was launched. That's a loss of 50% dollars. If you still managed to receive a certain number of coupons, for example, the note worked well for the first 2 years, which means you received 2 * 10% = 20% of coupons minus 50% loss = minus 30%. And you are now a proud shareholder of the American company Western Digital, which is little understood to you personally.

Let's try to analyze their pros and cons.

Pros of structured notes

To save time, I’ll say right away: from the point of view of the investor’s interests, there are none. But there are many advantages for those who sell them to you:

— High margins for business: sellers of 3-year notes in Russian investment companies and banks earn up to 18% of the deposited money. — Retention of client assets: you invest for 3-5 years and during this time you cannot sell the note, withdraw money, or you can, but with losses. -A tool that can be easily sold to uninformed investors by uninformed salespeople. “It’s almost like a deposit,” the pretty girls in the VIP branches of large Russian banks say without blinking, “a guaranteed coupon of 12% per annum in dollars - who else will offer you that much?” These are not my fantasies, this is my correspondence with the manager of the state bank. Moreover, apparently, the girl believes in this and does not realize the simple fact that any yield above the Fed rate (0.25% in dollars now) by definition carries a risk, not to mention 12% per annum in dollars.

Disadvantages of structured notes 1. Playing roulette In order to invest money in shares of specific companies, you need to understand them on a very deep, professional level. Otherwise, it is better to invest in stock indexes and not try to pick individual names. I wrote about this in detail in the article “I want to buy shares of Gazprom and Rosatom.” Moreover, when you use a note to bet on the stock market, your investment horizon is usually limited to 2-3-4 years. Nobody knows what will happen to the market, the economy and world politics over these 2-3-4 years: neither Warren Buffett, nor Donald Trump, nor Nassim Taleb. Your personal manager at the bank and his investment director also don’t know what will happen to the market and what the prospects of some American company are. If the investment director knew even a little, he would work in a hedge fund and earn millions of dollars, and not be involved in structuring notes in this bank for 300 thousand rubles a month. By betting on a note, you are making a statement that none of the 4 stocks will fall more than 35% over the next 3 years. This is a bold statement. As you know, there are 2 types of investors in the stock market: brave and experienced. As a rule, these are mutually exclusive qualities. You bet on the roulette wheel, consciously or not, and the note seller ends up as a dealer who will gladly accept your money.

2. The Worst of the World of Bonds and Stocks Very little has been invented in investing over the last couple of thousand years—the underlying asset is almost always either a share in a business (stocks) or a loan to a business (bonds). The shares have the advantage of potentially unlimited growth in income (225 thousand percent growth in Microsoft shares since going public in 1986) and growth in dividends; the disadvantage of shares is that their owners are not guaranteed an increase in the share price and are not guaranteed an increase in dividends. Bonds have the advantage of a stream of interest payments guaranteed by the borrower and a guarantee of repayment of the principal debt after a certain number of years; the disadvantage of bonds is the initially limited profitability of the loan, and the higher the yield of the bond, the more elusive the guarantee of repayment. Why is that? Because high yields on bonds are paid by those issuing companies that were unable to attract them at a low interest rate. These are higher-risk companies that can go bankrupt without ever repaying the investor, so their money-back guarantees aren't always worth the paper they're printed on. Now let's see what typical structural notes are. On the one hand, if you succeed, you get a fairly low income, comparable to high-yield speculative bonds: 8-12% per annum in dollars, as a rule, unless it is a note with unreliable shares of small companies. With unreliable stocks, returns can be even higher. Moreover, even this income will be taken away from you if all the shares in the note rise and the note is closed (“autocolnet”). Conclusion - with structured notes, income is not guaranteed, like with shares, income is limited by a ceiling (coupon size), like with bonds. At the same time, there are no guarantees of return of the invested amount, just as there are no guarantees for shares.

3. High hidden commissions The average hidden commission for a note seller is from 2% to 6% for each year of the note. That is, for a 3-year note, the bank’s income is from 6% to 18% of the amount you deposited. You have only just managed to deposit money to purchase the note, and the bank has already pocketed the profit. This is done by packaging these commissions into a note using option strategies, where you take on the risks, and the bank generously accepts the income. At the same time, what is most surprising, the bank incurs relatively small costs - if all the shares in the note begin to rise upward, then the bank has the option of automatic early redemption of the note (“autocall”), when it quickly returns the body of the note to you and stops paying coupons. That is, he will not pay you the full coupon for all 3 years (30%), but only for the last quarter - 2.5%. Excellent business, casino margins are much lower: in roulette with 2 zero sectors, on average the expected casino income is about 5.2% on each bet.

4. Risk of complete loss of capital Few of the clients who purchased notes understand that they can lose ENTIRE capital. If tomorrow one of 4 respectable companies (in our example: Biogen, Western Digital, Micron Technology, Discovery Inc.) declares bankruptcy and writes down its shares to zero, you will not get the average return of a basket of 4 issuers, but the worst stock that will turn into 0. The Worst of 4 Shares delivery term is what you agree to when purchasing a typical note. If the worst stock did not go to zero (as is now customary), but, for example, fell by 50%, you do not get the $100 thousand invested, but 50% * $100 thousand = $50 thousand. Losses may be greater than the “almost guaranteed income.”

5. Bank loyalty is an illusion Some clients think: okay, I’ll take a couple of boxes of these incomprehensible notes, they seem to have potentially good returns, and for this the bank will check my sources of funds less carefully. At least, that's what some enterprising bank managers promise their clients. As a result, a bank manager, if he receives a requirement from compliance to provide documents confirming income for a client, can do almost nothing, and the client’s profitability does not play any role here. The bank has already made money on it.

6. The game of the investor against the bank The investor’s income from the structured note is the investment bank’s expenses. Therefore, initially the bank issues such a note so that, in general, the expected return on the note for the bank is high due to commissions and losses for the investor. Of course, many banks PARTIALLY cover the risks of the notes they sell to clients, but only partially. There is still a conflict of interest: the bank needs to sell a good product to the client so that the client is satisfied, and the client’s income is the bank’s loss. Because of this fact, the terms of most notes imply the rapid closure of notes that are too successful for the investor (and unsuccessful for the bank).

7. Even in theory, the odds are against the investor. If the probability for each security that it will fall by more than 35% in 3 years is at least 20% (which is very optimistic), then this means that the probability of not falling is 80%. The probability that all 4 securities did not fall by more than 35% is 80% * 80% * 80% * 80% = 40.96% And this means that the probability of receiving a loss on the note is 100-40.96 = 59, 04%.

8. Risk of the issuing bank Adding a pinch of pepper to the dish, another cool property of the notes is the inability to sell on the public market. The liquidity of the notes varies from none (cannot be sold) to weak (many Western banks quote their notes, but with a spread of 2%-5%). Unlike a portfolio of individual stocks, you cannot kick a weak issuer out of a note if its business fundamentals have deteriorated. You are marrying someone you don’t know very well and the prospects for such a marriage are impossible to assess. A common myth is that a good company means good stock returns. In practice, Microsoft shares from 2000 to 2021 grew by only... zero percent! At the same time, Microsoft's business itself grew by tens of percent every year. The reason is that the stock price was too high in the early 2000s (this was the dot-com bubble). If the bank that issued the note accidentally goes bankrupt, you will naturally fall in line with the rest of the victims. So in reality you bear the risk not only of the 4 shares, but also of the bank that issued the note. Want to test your ability to understand individual bank risks?

Who are these financial instruments for?

In 2005, Michael Barry, a small American hedge fund manager, made a bet with Goldman Sachs and other major US investment banks. He bet the fund's entire capital that the subprime mortgage bond market would collapse and asked these banks to help structure a deal to buy credit default swaps (CDS) on those securities. He earned about $800 million from the stock market crisis in 2008. for himself and his clients, along the way, together with the same smart guys, bankrupting several banks.

Every financial instrument had a reason for its appearance and for its existence. There is a separate category of professionals who can assess all the risks and take a smarter position than an investment bank. But most likely, these guys are not your investment bank manager. This is a game of champions against champions, and we mere mortals can only read about it in books.

conclusions

1) Sellers of notes knowingly or unknowingly put customers at a disadvantage. I understand the guys perfectly: receiving 2-3% of the invested money in the form of bonuses right away, it is very difficult to abandon this practice. Moreover, this often works (when the market is in a phase of active growth). Unprofessional investors who see high numbers of “almost guaranteed returns” become greedy and take them, vaguely understanding that there may be a catch somewhere. But there is no free lunch in the stock market.

2) If you want high returns, invest in your business, in secured loans, in venture capital stories, in individual companies, if you are professional enough to assess their prospects over a horizon of 10 years or more, and be prepared to lose significant capital. . Promises of high returns in the stock market are a red flag for a professional investor.

3) Balanced index strategies work well in the stock market, which can provide low (at current interest rates 4-5% in dollars) with low risk or moderately high returns (6-10% in dollars) with moderate risk. Anything higher in yield can be a place for significant losses.

I wrote about what index investments are and how to make a balanced portfolio in the article “Why traditional index investments don’t work.”

Leveraged ETN and inverted notes

Some ETNs follow a predetermined leveraged index. This means that the issuer agrees to pay multiples for increases or decreases in the index. For example, if a note offers double leverage (2X), then if the index increases by 10%, the price of the note will increase by 20%. If you fall, the situation is similar. As a rule, the multiple appears directly in the name of the security (2X, 4X, etc.).

Inverted, inverted or reversed notes follow the index exactly the opposite way. As the index rises, the price of the ETN falls and vice versa. There are inverted notes with a shoulder.

Some leveraged notes are designed to produce, for example, double (2X) performance throughout the day. After this, the multiplier is “reset to zero” and starts again on the next trading day. Taking into account the reset over longer periods of time - a week or a month, ETN 2X will not necessarily provide double the return of the index.

Generally, leveraged ETNs and inverted notes are used by traders as a short-term instrument and are not intended for long-term investment.

Issuance, trading and redemption of ETNs

The list of exchange notes is available in the list of all securities of the exchange. Changes in the price of a note are associated with fluctuations in the index it follows, as well as with a number of other factors, including withdrawals from circulation and the issuance of additional notes.

The ETN issuer has the option to issue additional notes or withdraw the notes from circulation (repurchase). This feature is used to control the price of ETNs on the exchange. The issuer seeks to maintain the price of the ETN close to the “indicative price” or “indicative closing price,” which is determined daily by the value of the index and published at the end of the day. When an ETN is trading at a price above its indicative price (at a premium), issuing or issuing additional notes helps lower the price. Accordingly, if an ETN is trading below the indicative price (at a discount), the withdrawal of some securities from circulation helps to increase the price. For notes for which interim coupon payments are provided, the indicative price is not published.

What are bonds and how do they work?

To understand the principle of how a bond works, imagine Ivan Ivanovich going to the bank for a loan. He borrows 100 thousand rubles at 10% per annum. Bonds are based on the same lending, only you lend. And the company will owe you money. Such a company (or government, if we are talking about government or municipal bonds) is called the issuer. And the debt is at face value.

In addition to the principal debt, there is also interest for using the money. In financial parlance, this is a coupon. More often than not, coupons are paid twice a year. For example, if you buy a bond with a nominal value of 1000 rubles, a coupon of 10% per annum and payment twice a year, then every six months you will receive a coupon of 50 rubles.

When a bank issues a loan, it evaluates the borrower's past and present, salary, family composition and the current economy in the country - all of which together determine whether the loan is justified. Study your borrower too.

Indicative price and market price

The indicative price of the notes differs from the current market price of the exchange-traded note. In theory, the market price of an ETN should be very close to the price of the index that the note follows. In practice, the price on the exchange may differ significantly from the indicative one.

Price discrepancies can happen for various reasons. For example, a note may trade at a significant premium to the indicative price if the issuer for some reason has stopped issuing additional securities. In the history of trading on the NYSE, there have been situations where trading has occurred at a premium that exceeded 90% of the indicative price. After the resumption of issuance of new securities, the price dropped sharply. The purchase of such a security may result in significant losses to the investor.

Therefore, before purchasing an exchange-traded note, it is recommended to compare the indicative price with the current market price. If there is a significant divergence between the market and reference prices of an ETN, it is best to consider purchasing an alternative security that tracks an identical asset, but without a significant premium. It is also a good idea to find out whether the issuer has stopped issuing new securities. If this is so, then what is the reason for this decision? You can also ask the broker what types of trading orders are accepted in relation to this security, and what will happen if the note ceases to be sold (is delisted) on the exchange.

Yield of structured bonds

As a rule, such financial instruments are declared with increased profitability. The declared yield on average exceeds the average OFZ rate by 2-3 times, which attracts ordinary citizens. Apparently, this is how banks want to avoid scaring off customers with large numbers.

For example, if the current key rate of the Central Bank of the Russian Federation is 4.25%, then for an investment product they can offer about 8-10%. That is twice as much. Seeing such numbers, clients may not notice the conditions: such high profitability is obtained only if a number of conditions built into the strategy are met. If they are not fulfilled, then there are two possible options:

1. The client suffers a loss on investments, up to 100%;
2. The client gets back only the money invested (it turns out that it just lay there for several years);

If the conditions of the strategy are met, the investor will receive income, otherwise he will incur a loss. The conditions laid down in the strategy do not depend in any way on the investor. Whether the conditions are met or not is decided only by chance.

What may be included in the conditions? As a rule, this is a combination of a group of factors on the value of some assets on a specific date:

• Dollar Value Corridor;
• Stock index price corridor;
• Share group prices;
• Bond group prices;
• Commodity prices;

For example, will the dollar be in the range of 70-80 rubles in exactly 1 year? If yes, then the investor receives a coupon income, otherwise not. Another example: not a single top stock from the IT sector will fall by more than 20% of its current value in exactly 6 months. This could be 4 shares: Apple, Google, Amazon, Facebook.

Such conditions are more like a guessing game than an investment.

Risks to weigh

• Credit risk Exchange notes are unsecured debt obligations of a bank (or other company). If the bank defaults on the notes, the investor could lose some or all of the money.
• Market Risk The price of the ETN is determined by trading on an exchange. If the value of the index that a note follows changes, the price of the note will also fall or rise. In this regard, although a note is a debt obligation, its price is often much more volatile than the price of bonds. If the note tracks more than one index, but several market benchmarks, and the formula by which the bank's liabilities are determined is not fully understood or is not clearly stated in the prospectus, it is better to refuse the purchase. The prospectus of the note must be studied before purchasing without fail.
• Liquidity Risk Although an ETN is an exchange-traded product, this type of security may involve liquidity risk. As is the case with other exchange-traded securities, the popularity of this product may simply not provide the required number of applications for purchase/sale among investors. In addition, under certain circumstances, the issuer may delist the note and it will no longer be traded on the exchange. It will be quite difficult to sell such paper.
• Following risk The price of an exchange-traded note under normal conditions is quite close to the indicative price, calculated using a formula depending on the value of the benchmark. However, this does not always happen for the reasons described above.
• Holding Risk Some ETNs, particularly inverse or leveraged notes, are designed as short-term speculative instruments. Taking into account the effect of capitalization, the performance of these securities over long periods may differ significantly from the stated multiples compared to the index performance.
• Early Redemption Risk Some ETNs provide the option for the issuer to redeem the security before the end of its maturity. Since obligations in this case can be repaid at any time, the amount paid may be lower than the market price or even equal to zero.
• Conflicts of Interest There are several potential conflicts of interest between an investor and an ETN issuer. For example, the issuer of a note may engage in trading activity that causes the price of the note to decline. When studying the note prospectus, you need to pay attention to places where “conflicts of interests” are mentioned (“Conflicts of interests” - in the English version).

Before purchasing sheet music

Before purchasing an ETN, make sure you understand the answers to the following questions:

• Who is the issuer of the note? Once you find out who the ETN issuer is, check their credit rating and inquire about their current financial situation. If the issuer is a public company, find information about it on the website (for Russian companies) and in the system (for US companies). It is important to understand that notes may not be issued by investment companies. In this regard, the regulatory framework for reporting of such companies will differ from traditional mutual funds, mutual funds or ETFs. Particular caution should be exercised in relation to securities issued by foreign offshore companies without an international rating or with a low rating.
• What index does the note follow? If the benchmark for an ETN is an index, market or individual asset that is poorly familiar to the investor (sometimes a complex set of assets is offered), most likely it will not be possible to adequately assess the risks of such an investment. It is better not to buy such a note until there is complete clarity with the benchmark itself and the formula by which the payment schedule is determined.
• Is there an early redemption option for ETNs? This opportunity is sometimes called a put or put option. Information about this must be set out in the security prospectus. If there is no clarity, it is better to contact the issuer with a question.
• Is the ETN inverse and does it have leverage? If so, how often does his multiplier reset? Most often, in addition to the multiplier multiplier (2X, 4X, etc.), the name of the ETN contains words such as “daily” or “short-term”, which indicate the frequency of resetting. In any case, leveraged ETNs and inverse notes are not intended to be long-term investments.
• What fees are involved in owning a note? Exchange-traded notes differ significantly in terms of commission fees. Additional fees may be associated with, for example, ETN redemptions. Read the prospectus or find out from the issuer exactly what fees are involved in holding, purchasing or redeeming a security.
• What taxes do I need to pay? Taxes may vary greatly depending on the type of note. It is better to consult a specialist about the specific tax amount.

Exchange-traded notes, although they look attractive and simple at first glance, are associated with additional risks. The essence of an ETN is significantly different from ETFs, mutual funds or mutual funds (for the USA).

This article was prepared based on (FINRA).

Tags: ETN ETF Exchange Note Structured Products

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— Loading trading history of stocks, ETFs, indices and currencies: new EXCEL function

— News of Russian mutual funds and ETFs. December 2020

Comments (0)

1. Sergey February 06, 2021, 12:36 0
   It seems that note holders will be the first to suffer from the volatility jump:

   answer

Is it worth buying a joint venture?

If you are not a professional speculator who does not have intuition and is in the market and knows the most complex methods and tools, then a structured product is not the best solution for you. It’s easier to open a brokerage account yourself, save on commissions and start building your own investment portfolio. If you understand this process in detail, where to start, how to choose a broker and what to pay attention to first, you can start earning money on your own