Investors have a plethora of products to choose from these days. Many of them may be overkill for small investors. They may not be bad or terrible investments in general, but they're the wrong tool for most people.
Exchange traded notes are one such product, generally speaking. They're like exchange traded funds, but instead of owning the underlying investments, the investor gets a promise from the issuer of the ETN that it will pay the returns of the underlying securities.
"ETNs carry two primary types of risks," says Jonathan Duong, CFA, Certified Financial Planner, founder and president of Wealth Engineers in Denver, Colo.
"The reason why companies issue ETNs instead of ETFs is usually due to underlying tax complications, liquidity issues or other complexities that make holding the securities directly a bit challenging," says J. David Stein, a former chief investment strategist for an institutional investment adviser and current writer and educator at his website jdavidstein.com.
If the issuer goes bankrupt, investors are basically out of luck. Issuers can also stop creating new notes, which can send the price spiraling up if investors keep clamoring to buy. An unwary investor could get caught up in the melee and lose lots of money. That happened in 2012 with a volatility index-linked ETN issued by Credit Suisse.
The saga of that particular ETN -- TVIX -- highlights many of the dangers of these instruments. Many ETNs invest in futures, use leverage and may move inversely to the index they're tracking. They're very complicated and most of the time, naive investors who don't read the prospectus don't get a crack at a lawsuit.
One lucky speculator did though. Here's what happened.
In the story "How a 56-year-old engineer's $45,000 loss spurred SEC probe," Bloomberg.com covered the regulatory fallout resulting from a lawsuit filed by a group of investors against Credit Suisse back in 2012. The suit alleged that the risks of the investment related to the issuer halting issuance of shares and then recommencing were understated in the prospectus. In the Bloomberg story, an unwitting investor, Jeff Steckbeck, reported that he had not actually read the prospectus and had been advised not to buy TVIX. Nevertheless, he believed that Credit Suisse had been remiss in its handling of the situation.
Now the SEC is mulling increased disclosure requirements. Arguably though, if investors don't read the prospectus and ignore advice, disclosures that aren't attached to a bucket of cold water may be less than effective.
The bottom line is that high-risk alternative asset classes can be profitable in the right hands, but those hands are probably not attached to most individual investors. When in doubt, it's probably best to follow the advice of the Oracle of Omaha, Warren Buffett: Don't invest in things you don't understand.
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Senior investing reporter Sheyna Steiner is a co-author of "Future Millionaires' Guidebook," an e-book written by Bankrate editors and reporters. It's available at all the major e-book retailers.