{"id":3420,"date":"2024-11-19T18:55:25","date_gmt":"2024-11-19T18:55:25","guid":{"rendered":"http:\/\/blog.valuengine.com\/?p=3420"},"modified":"2024-11-20T21:51:31","modified_gmt":"2024-11-20T21:51:31","slug":"georgia-broker-dealer-learns-costly-lesson-from-finra-on-etns-vs-etfs-a-discussion-on-etf-construction-and-affects-on-risk-and-taxes","status":"publish","type":"post","link":"http:\/\/blog.valuengine.com\/index.php\/georgia-broker-dealer-learns-costly-lesson-from-finra-on-etns-vs-etfs-a-discussion-on-etf-construction-and-affects-on-risk-and-taxes\/","title":{"rendered":"Georgia Broker-Dealer Learns Costly Lesson From FINRA on ETNs vs. ETFs: A Discussion on ETF Construction and Affects on Risk and Taxes"},"content":{"rendered":"

A Georgia-based brokerage has settled allegations that it and its president developed and sold a trading strategy that they did not understand and that caused near-total losses for 350 clients, according to the Financial Industry Regulatory Authority as reported by Financial Advisor Magazine recently.\u00a0 The brokerage had agreed to $2 million in partial restitution to those clients and a censure.\u00a0 The former president agreed to pay $15,000 and accepted two concurrent suspensions from dealing with the industry for more than a year.\u00a0 There are no allegations the firm was not intending to act in the best interests of their clients.\u00a0 It seems clear that the firm, and the former president, did not understand fully how the product worked. The full article can be read here <\/span>https:\/\/www.fa-mag.com\/news\/georgia-b-d-to-pay–2m-to-clients-for-allegedly-selling-unsuitable-products-80231.html<\/span><\/a><\/p>\n

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The product in question, the Daily Inverse VIX Short-Term Exchange-Traded Note, had the ticker symbol <\/span>XIV.\u00a0 <\/b>It was structured as<\/span> an Exchange-Traded Note, sometimes called an ETN.\u00a0 ETNs are essentially structured products that are issued as senior debt notes and trade as stocks.\u00a0 They have credit risk linked to the issuer which may or may not be the note\u2019s sponsor. They are designed as trading vehicles but own no underlying stocks or bonds.\u00a0 However, despite having no structural commonality with mutual funds, ETNs are frequently categorized as ETFs and lumped in with ETFs in stock price quotation listings in financial media.\u00a0\u00a0\u00a0<\/span><\/p>\n

The Exchange Traded Note in question was issued by Credit Suisse and sponsored by DirexionShares, an ETF issuer that specializes primarily but not exclusively in leveraged ETFs and structured notes. For many months since its introduction, the product had produced excellent weekly price gains with low price volatility. As long as VIX, CBOE\u2019s volatility index on the S&P 500, had no sudden upward spikes, <\/span>XIV <\/b>provided small but steady weekly gains. Unfortunately, the calculation of the note resulted in an exponential loss caused by a huge spike which wiped out years of gains and more in one day.\u00a0 Many financial advisors are not experts in the mathematics behind structured notes and potentially severe one-day price movements. The vast majority of advisors\u2019 clients and retail customers typically have even less understanding of them.\u00a0\u00a0\u00a0<\/span><\/p>\n

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How could this happen when ETFs are generally considered prudent investment vehicles and are backed by the securities they own?\u00a0 At the heart of the issue is the fact the \u201cF\u201d in the term ETF refers to \u201cfund.\u201d\u00a0 True Exchange-Trades Funds (ETFs) ARE mutual funds, a fact that various investment publications continue to misunderstand and get confused by.\u00a0 ETFs have the same applications and requirements as other mutual funds and are similarly governed by the Securities Act of 1940. Like other mutual funds, they can be index-linked or actively managed. The major differences are that most shareholders buy or sell ETF shares through brokerage accounts whereas traditionally structured mutual funds are bought or redeemed daily through the mutual fund\u2019s distributor.\u00a0 ETFs have an exemption to the \u201credeem daily at the distributor for cash on demand\u201d provision.\u00a0\u00a0<\/span><\/p>\n

The major twist with ETFs is that while new fund shares can be created or redeemed daily with the distributor, they can only be created and redeemed through authorized participants in very large quantities, generally at a size of more than $25,000 per transaction.\u00a0 These participants buy tens of fund shares at a time.\u00a0 For equity ETFs, they typically do so by contributing baskets of \u201cin-kind stocks\u201d requested by the\u00a0 fund. They can be thought of as miniature replicas of the fund\u2019s constituents in the proportion held by the fund. To sell fund shares back to the fund itself, participants send the requested amount of fund shares per basket to the fund and receive baskets of the underlying securities in return.\u00a0 This diagram is a big picture view of the process.<\/span><\/p>\n

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This complex-sounding redemption process, now done routinely every day, is considered a free-receipt-and delivery process.\u00a0 Unlike selling securities for cash, the free-receipt-and-delivery process is not subject to capital gains tax. Thus, ETFs generally do not need to make capital gains distributions to fund shareholders as traditional mutual funds do.\u00a0\u00a0<\/span><\/p>\n

Beyond taxation, the exchange-traded fund structure holds many advantages for both fund shareholders and fund companies.\u00a0 To learn more, please read \u201cLeveling the Playing Field for Active Managers\u201d available on the ValuEngine site at https:\/\/ww2.valuengine.com\/research-library\/<\/a><\/span><\/p>\n

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This begs the question, \u201cIf ETFs are just more efficiently structured mutual funds, how do ETNs and other vehicles such as grantor trusts and commodity pool shares get confused by investment professionals with ETFs?\u00a0 The ultimate answer is by failing to read and understand the summary prospectus.\u00a0 This is something any investment professional should be expected to do automatically before buying or selling anything on behalf of a client.\u00a0 Unfortunately, I have been stunned how often these products are bought on exchange without doing so. Judging the safety or suitability of an investment product solely based upon its name and historical performance data is a prescription for disaster.<\/span><\/p>\n

In my years as a consultant, I have run into many cases where investors and traders simply do not understand math behind inverse and leveraged ETFs and the implications of that math on return streams.\u00a0 Frequently, the expectation is that if I buy an inverse 2X S&P 500 ETF on May 31 and the Index goes down 5% in June, I should gain 10% for the month.\u00a0 In reality, the mathematics behind daily futures compounding works very differently.\u00a0 No one should buy or sell products that buy or sell daily index futures as buy and hold tools.\u00a0 They are designed for daily or hourly trading.<\/span><\/p>\n

Another part of the confusion is the term \u201cETF wrapper.\u201d It is used in almost every investment webinar I attend these days.\u00a0 \u201cWrapper\u201d has no standing in investment law or with the SEC.\u00a0 It actually comes from old mutual fund jargon about different classes of fund shares offered to differentiated types of investors (e.g., 401K plan, High New Worth, etc.).\u00a0 Since all types of investors have equal access to buy and sell ETF shares at the same price and fees and tax treatments, the word \u201cwrapper\u201d shouldn\u2019t really apply.\u00a0 Moreover, I believe it demeans the actual structural advantages of the Exchange-traded-fund. At any rate, \u201cexperts\u201d describe mutual funds now structured as ETFs as \u201cbeing in the ETF wrapper.\u201d\u00a0 Unfortunately, they also describe many other products as ETFs with the justification that \u201cthey use the ETF wrapper.\u201d\u00a0\u00a0<\/span><\/p>\n

Using \u2018ETF\u2019 to describe something not associated with a mutual fund is not a new sleight-of-tongue. Experts have done it for years over the objections of investor education advocates.\u00a0<\/span><\/p>\n

The trend really became in vogue with <\/span>GLD, <\/b>a depository receipt on physical gold, launched by State Street Global Advisors in cooperation with the World Gold Council in 2003.\u00a0 The structure was modeled after an ADR using the legal vehicle of a special type of trust called a Grantor Trust.\u00a0 A share of <\/span>GLD <\/b>is a share of a trust that can hold precious metals, currencies, foreign stocks, land deeds and many other things.\u00a0 The shares trade on stock exchanges.\u00a0 Upon sales, investors are taxed as if they had sold a pro rata portion of the underlying assets.\u00a0 Thus, they do not have the tax advantages of ETFs but a different tax treatment altogether. There is no underlying mutual fund and no portfolio manager.\u00a0 However, ETFs such as the fund based on the Nasdaq-100, <\/span>QQQ, <\/b>and the one based on the S&P 500, <\/span>SPY <\/b>were gaining in popularity at this time. They were starting to catch financial advisor\u2019s imaginations as investments that allowed institutional index products to trade like stocks, thus democratizing investing.\u00a0 State Street, iShares, Vanguard, and First Trust were among those actively visiting planners and advisors on how ETFs allowed access to different asset classes in a single trade.\u00a0 Once <\/span>GLD <\/b>allowed gold to be traded just like a stock, the investment media and many industry professionals viewed it as an extension of the ETF revolution. The distinction that <\/span>GLD <\/b>had a completely different structure with a different tax treatment seemed unimportant compared to sharing a good story about another exchange-traded product that changed the face of investing.<\/span><\/p>\n

Current ValuEngine reports on all covered stocks and ETFS can be viewed<\/b> HERE<\/b><\/a><\/h5>\n

This watershed event explains how products reflecting non-traditional-assets-with-financial-value that use the Grantor Trust and similar structures are now commonly called ETFs despite the fact that there is no actual fund associated with the product.\u00a0 Other products called ETFs with no fund include:<\/span><\/p>\n