Imagine losing more than $800,000 investing. Now, imagine losing $800,000 investing in just two weeks. Recently, The Wall Street Journal featured the story of William Mark, an investor determined to recoup some of the losses he suffered in the financial crisis of 2008. In order to turbocharge his returns, he invested in less traditional vehicles, including exchange-traded notes, or ETNs.
Mr. Mark quickly made some money off the investment, notching an eye-catching 18% return. Those returns evaporated, however, as the global economy ground to a standstill in March amid the COVID-19 pandemic. In this article, we’ll look at the ETN to determine whether the buyers of these products were just unlucky, or whether the brokers who sell them failed to disclose just how risky of an investment they were.
What Are ETNs?
ETNs, exchange-traded notes, are unsecured debt securities that track an index. They seem like a hybrid between a stock and a bond. Like stocks, they trade on a major exchange. However, they are considered a bond even though they do not make periodic interest payments like other types of bonds. Their return is based on market index. Their exchange rate goes up and down as the market changes.
The financial institution pays the investor an amount of money correlated to the performance of the index, less any fees, when the investment matures. Investors make money by selling the ETN for more than the amount they paid for it. Investors do not own the securities; instead, they are paid based on the rate of return of the index. Investors can lose money on ETNs if the index decreases or does not earn more than the fees the investor incurs.
With ETNs, investors bet on how well various markets and products will perform, including the stock market, the future value of currency in other countries, wheat, oil pipeline rights, small business loans, or many other things. Financial institutions often have the option to remove these investments from the market if their value declines to a certain level.
Many ETNs are leveraged, meaning that they amplify gains and losses through borrowed money. For example, if an ETN has 2x leverage and there is a 2% gain in the market, the ETN could experience a 4% gain (the number may not be an exact multiple; it could vary depending on the overall asset mix in the ETN). Likewise, if the value of the underlying index fell 2%, the value of the ETN could drop by 4% or more.
Some external factors can affect the value of the ETN, including the issuer’s credit rating. Additionally, economic, political, legal, or regulatory changes can impact whether the financial institution will actually be able to pay investors. In some situations, the institutions default on the bond.
Recent History of ETNs
In 2008, banks cut interest rates during the economic recession at that time. While this had the positive effect of stabilizing the financial system, it also caused the safest investments like bonds to provide much lower payouts to investors. Therefore, some investors went looking for riskier options that might provide higher rates of returns. ETNs fit the bill for about a decade.
In 2008 and 2009, brokers from Citigroup Inc., Wells Fargo & Co., and Morgan Stanley & Co. sold billions of similar investment vehicles called exchange-traded funds, but some brokers refused to sell these because of the risks and high fees involved.
In 2012, regulators sanctioned financial institutions for failing to educate their investors about the risks of leveraged exchange-traded funds. However, this did not stop many of them from continuing to market these investments as offering payouts that were steadier and higher than other investment options. While the economy was doing just fine, the investments did, in fact, make a lot of money.
However, that all changed recently. COVID-19 happened, causing an economic collapse felt throughout the world. Several banks who sold the products have lost billions of dollars in 2020. Individual investors like William Mark have also lost their lifetime savings after their bet on ETNs did not pay off.
How the Marks Lost Their Money
William Mark purchased his leveraged ETN in 2012 from UBS, a Swiss bank with a history of shady practices when it comes to selling its products. The fund wagered on companies that invested in the mortgage market. The particular type of investment Mr. Mark had returned a significant portion of its profits through the distribution of dividends. In 2019, bets on the mortgage market were paying out well. However, when the coronavirus situation caused extreme volatility in the financial markets, many businesses frantically searched for cash and tapped into borrowing markets that investments like Mr. Mark’s relied on. The value of ETNs leveraged on mortgage investment firms quickly declined.
UBS removed at least 15 ETNs form the market after they quickly declined in value. When this occurs, investors typically only receive a small fraction of their initial investment.
Not an Isolated Incident
Sadly, Mr. Mark was not the only one to lose his complete retirement, according to The Wall Street Journal piece. The article detailed how other investors like Mr. Mark also lost their life savings by betting on ETNs. One of the investors profiled said he was suing his broker for not providing proper disclosures before selling him the investment. Another said that he does not blame his broker and knew that the investment was risky.
What Duty Does an Investment Broker Owe to an Investor?
Regardless of whether the victims of ETNs blame the broker who sold them the investment, the financial professional owes a duty of care to the investor. If the broker fails to meet the standard of fair dealing, they have committed securities fraud by engaging in broker misconduct. “Broker misconduct” occurs any time a broker fails to act in the best interests of the client. This basic duty, to protect the customer from financial risk, is known as the “duty of fair dealing.”
Investors put their trust in financial products brokers to provide direction for their investment decisions. As licensed professionals, there is a heightened level of trust that is expected and indeed required by law from brokers; this includes:
- Providing investment advice that is suitable for the individual investor it is given to
- Giving fair and balanced risk disclosures about the products the broker is selling
- Disclosing conflicts of interest
These duties, encoded in regulations and laws by the SEC, FINRA and state and federal securities laws, require brokers to adhere to a high standard of conduct. Unfortunately, unscrupulous individuals and the brokerage firms that employ them often recommend investments that put the profits of the firm ahead of the need of the investor.
What Are My Options If I Invested in an ETN?
If you were sold an ETN product by your broker and suffered financial losses as a result, we want to hear from you. Our experienced attorneys are highly skilled at identifying broker misconduct and, more importantly, proving it in court. Contact us today to discuss your options.