Exchange Traded Notes - Another case of Investment Pornography?
I was reading an article in the Wall Street Journal a couple weeks ago about a few investors who lost almost all of their retirement savings in just a matter of a couple of weeks! We've heard stories like that, but how does that even happen? How do people end up in that situation? Let’s break it down.
Here’s what happened: These individuals invested in a risky product called an Exchange-Traded Note (ETN), not to be confused with an Exchange-Traded Fund (ETF) that we hear so much about. Exchange-Traded Funds are like mutual funds, but these Exchange-Traded Notes are very different. They are basically a debt instrument, through a bank or brokerage firm, that offers to pay you the return of an underlying index (eg. S&P 500, Russell 2000, etc.). The difference between these risky ETNs is that they don't actually own the index, or anything other than options and complicated derivative products.
HOW DO EXCHANGE-TRADED NOTES WORK?
A lot of these underlying indexes can invest in almost anything like stocks, commodities, real estate, mortgage REITs, and currencies. If it has an index, it could have Exchange-Traded Note following it. The bank or brokerage firm borrows money so that they can give you X times the return of the underlying index. For example, if the underlying stock index (like the S&P 500) went up by 5% during the month, they would pay you 10%. But let's say if it went down by 10% in the month, you would lose 20%. So you can see how losses and gains are magnified. As long as things are going good on the upside, then it turns out to be a great deal, because you're getting multiple times the market return. Here’s the big problem with that: When we get into a financial crisis like we just faced in March 2020, the losses can be absolutely devastating.
WHAT WENT WRONG?
So when the market came crashing down, oil prices tumbled, and mortgage interest was not being paid due to the pandemic, a lot of those leveraged notes started to lose multiple times. Not only did they lose significant amounts like you might have seen in the stock market (~37%), but these ETNs lost almost all of their value. And while the stock market has already recovered substantially, these ETNs have not recovered. Banks have already redeemed, closed, or liquidated several ETNs. That means that some of these investors who are all featured in the WSJ article received pennies on the dollar for their original investment in these ETNs. These people invested their retirement savings in these vehicles trying to catch up after the 2008-09 crisis. Back then, they sold their equity positions at the bottom, didn't ride the recovery back up, sat out for a few years, and therefore missed a good chunk of the recovery.
Then they tried jumping back in and were allured by these high returns offered by these leveraged Exchanged-Traded Notes, believing the lie that these would be less volatile than equity securities and pay higher returns than bonds. What they didn't understand was the complexity of the leverage, and how crisis events like we are experiencing now could wipe out investments like this.
THERE IS NO SUCH THINGS AS A FREE LUNCH
Professional wealth advisors who understood the products stayed away from them. It was the do-it-yourself people that didn't know how bad they could get hurt. They jumped into the lure of the investment pornography being pitched by banks and brokerage houses. Remember this: In financial markets, there is no such thing as a free lunch. High returns always come with high risks. Always. There's no exception.
It's a well-worn phrase, but well-worn for a reason: “If it's too good to be true, it probably is.” So next time you're tempted by something that sounds too good to be true and you're being lured by some promise of high return and little risk, please call a financial advisor. Ask them to take a look at it before you jump in, and make sure the financial advisor has the credentials enabling them to be able to adequately assess the risks of the underlying product.
