Key Takeaways
- Structured products combine securities with derivatives to create specific risk/return profiles.
- ETNs are unsecured debt obligations linked to an index - have CREDIT RISK of issuer.
- Principal-protected notes guarantee return of principal but cap upside.
- Leveraged ETFs deliver DAILY multiples (2x, 3x) and reset daily.
- Inverse ETFs profit when the underlying index DECLINES.
- Leveraged/inverse ETFs are NOT suitable for long-term buy-and-hold due to daily compounding decay.
- Viatical settlements involve purchasing life insurance from terminally ill individuals.
- Complex products require enhanced suitability analysis and disclosure.
Structured Products and Complex Investments
These complex products combine traditional securities with derivatives to create specific risk/return profiles. They require enhanced understanding and suitability analysis.
Exchange-Traded Notes (ETNs)
ETNs are unsecured debt obligations issued by financial institutions.
ETN Characteristics
| Feature | Description |
|---|---|
| Structure | Senior unsecured debt |
| Returns | Linked to index performance |
| Credit Risk | Issuer default risk (unlike ETFs) |
| Tracking | No tracking error (unlike ETFs) |
| Maturity | Fixed maturity date |
| Tax Treatment | May be more tax-efficient |
ETN vs. ETF Comparison
| Factor | ETN | ETF |
|---|---|---|
| Structure | Debt obligation | Trust holding assets |
| Credit Risk | Yes (issuer) | No (owns assets) |
| Tracking Error | No | Yes (possible) |
| Asset Ownership | No underlying assets | Holds underlying assets |
| Counterparty Risk | Yes | Minimal |
ETN Risks
| Risk | Description |
|---|---|
| Credit/Default Risk | Issuer may default |
| Call Risk | May be called before maturity |
| Liquidity Risk | May be difficult to sell |
| Market Risk | Linked index may decline |
Exam Tip: ETNs have CREDIT RISK of the issuing bank because they are unsecured debt. If the bank fails, ETN holders may lose their investment. ETFs do NOT have this risk.
Principal-Protected Notes
Principal-protected notes (PPNs) guarantee return of principal at maturity while linking returns to market performance.
PPN Characteristics
| Feature | Description |
|---|---|
| Principal | Guaranteed at maturity |
| Upside | Linked to index/asset performance |
| Cap | Maximum return often limited |
| Participation | May receive only portion of gains |
| Maturity | Must hold to maturity for protection |
| Credit Risk | Guarantee only as good as issuer |
PPN Components
| Component | Source |
|---|---|
| Zero-Coupon Bond | Provides principal protection |
| Call Option | Provides upside participation |
PPN Considerations
| Pro | Con |
|---|---|
| Principal protection | Capped returns |
| Market participation | Credit risk of issuer |
| Known worst-case outcome | Illiquid |
| No dividends received |
Leveraged ETFs
Leveraged ETFs seek to deliver multiples of daily returns of an underlying index.
Types of Leveraged ETFs
| Type | Daily Target Return |
|---|---|
| 2x Long | 2 times index return |
| 3x Long | 3 times index return |
| -1x (Inverse) | Opposite of index |
| -2x | 2 times opposite |
| -3x | 3 times opposite |
The Daily Reset Problem
Leveraged ETFs reset daily, creating compounding decay over time.
Math Example: Index Up 10%, Then Down 10%
| Investment | Day 1 (+10%) | Day 2 (-10%) | Total Return |
|---|---|---|---|
| Index | 100 → 110 | 110 → 99 | -1% |
| 2x Leveraged | 100 → 120 | 120 → 96 | -4% |
| 3x Leveraged | 100 → 130 | 130 → 91 | -9% |
Key Insight: Even though the index only lost 1%, the 2x ETF lost 4% and the 3x ETF lost 9% due to daily compounding.
Volatility Decay
In sideways, volatile markets:
- Leveraged ETFs lose value over time even if index is flat
- Called "volatility decay" or "beta slippage"
- More pronounced with higher leverage
Leveraged ETF Suitability
| Suitable For | NOT Suitable For |
|---|---|
| Short-term trading | Long-term buy-and-hold |
| Sophisticated traders | Retirement accounts |
| Daily hedging | Conservative investors |
| Intraday speculation | Passive investors |
Exam Tip: Leveraged ETFs are for DAILY trading only. They should NEVER be recommended for long-term holding. Daily reset causes returns to differ significantly from expected multiples over time.
Inverse ETFs
Inverse ETFs are designed to profit when the underlying index declines.
Inverse ETF Uses
| Use | Description |
|---|---|
| Hedging | Protect against market decline |
| Speculation | Bet on market downturn |
| Short Exposure | Without margin account |
Same Daily Reset Issues
- Reset daily like leveraged ETFs
- Subject to volatility decay
- NOT suitable for long-term hedging
- Returns diverge from expected over time
Viatical and Life Settlements
These involve purchasing life insurance policies from policy owners.
Definitions
| Type | Policy Owner |
|---|---|
| Viatical Settlement | Terminally ill (life expectancy < 2 years) |
| Life Settlement | Elderly but not terminally ill |
How They Work
- Policy owner sells policy for cash (more than surrender value)
- Buyer becomes new owner and beneficiary
- Buyer pays ongoing premiums
- Buyer receives death benefit when insured dies
Key Risks
| Risk | Description |
|---|---|
| Longevity Risk | Insured lives longer than expected |
| Premium Risk | Must pay premiums until death |
| Fraud Risk | Misrepresentation of health |
| Liquidity Risk | Difficult to resell |
| Ethical Concerns | Profiting from death |
Regulatory Considerations
- Regulated by states as insurance products
- May also be securities (SEC involvement)
- Disclosure requirements vary by state
- Suitability requirements apply
Complex Product Suitability
FINRA Guidance on Complex Products
| Requirement | Description |
|---|---|
| Enhanced Suitability | Must understand product complexity |
| Reasonable Basis | Firm must understand product |
| Customer-Specific | Must be suitable for individual |
| Quantitative | Not excessive for customer |
| Documentation | Must document suitability analysis |
Due Diligence Requirements
| Factor | Consideration |
|---|---|
| Complexity | Can customer understand it? |
| Costs | Are fees reasonable? |
| Liquidity | Can customer access funds? |
| Risks | Does customer understand all risks? |
| Alternatives | Are simpler products available? |
Exam Tip: Complex products require enhanced suitability analysis. Always consider whether a simpler product would meet the customer's needs.
A leveraged 2x ETF is designed to:
What is the primary risk unique to ETNs that ETFs do not have?
Which statement about leveraged ETFs is TRUE?
A viatical settlement involves:
7.1 Types of Clients
Chapter 7: Client Types and Profiles