Why ETNs are Riskier Than They Look

Co-editor of Weiss Research’s International ETF Trader

Mike Larson is off today, so he asked me to fill in for him. And one thing that I think Mike and I both agree on is that ETFs, or exchange traded funds, are one of the best things that ever happened for small investors.

You may already know about the advantages they have over conventional mutual funds … liquidity, low costs, transparency, diversification, and more.

What you may not know is that there is a new investment that looks a lot like an ETF but is actually a whole different species. I’m talking about ETNs: exchange traded notes.

On the surface, ETNs share many of the characteristics of ETFs. You can buy and sell them on the stock exchange throughout the day, their performance closely mirrors an index, and they give you access to specialized market niches like commodities and currencies.

However,

There is One Gigantic Difference …
An ETN Is Really a Bond!

That’s why they’re called “notes” rather than “funds.” Yet it usually doesn’t pay interest at a fixed rate, like say a Treasury bond would. Instead your “interest” is the return on a designated index.

Let’s look at an example:

The iPath S&P GSCI Crude Oil ETN (OIL) is very popular right now. It’s designed to track the return of a crude oil price index. This gives you a way to participate in the crude oil market without using more complicated and risky tools like futures.

When you buy the OIL ETN you’re not buying oil. You’re buying a promise from the issuer to pay you some date in the future.

When you buy the OIL ETN, are you actually buying oil? No, you’re not. What you are buying is a promise from the issuer — British banking giant Barclays, the corporate parent of iPath — to pay you a return linked to the performance of the Goldman Sachs Crude Oil Return Index at some date in the future.

So with OIL you don’t get any oil, directly or indirectly. All you get is a promise from Barclays Bank that you’ll be repaid when the ETN matures, with no claim on any particular assets. You are now an unsecured creditor of Barclays.

This brings up another question: What guarantee do you have that Barclays Bank will be around to make good on its promise? Answer: none.

If Barclays should fail for any reason — even something completely unrelated to this particular ETN — the promise you bought could go up in smoke. You’ll be just another creditor when the bankruptcy court divides up whatever is left of Barclays.

Now compare this to an ETF …

In the U.S., ETFs are regulated under the Investment Company Act of 1940. They are chartered as separate corporations. The ETF’s board of directors hires a manager to keep things going and you, as an investor, own shares of the corporation.

Before Lehman Brothers went belly up, it launched three ETNs in early 2008. All three have bit the dust.

If the manager of an ETF goes bankrupt, what happens to the assets of the ETF? Nothing. There might be a temporary disruption while the board finds a new manager, but the underlying stocks, bonds or other instruments in the fund will be secure. Not so with an ETN.

Think it can’t happen? It already has!

The now-defunct Lehman Brothers launched three ETNs in early 2008 under the “Opta” brand name. The ticker symbols were EOH, PPE and RAW. Look them up and you’ll find they aren’t around anymore.

When Lehman failed in September, owners of those three ETNs found themselves holding the short end of the stick. Now their money is tied up in one of the most complicated bankruptcy cases ever. It could be years before they get anything back, if ever.

There are other examples, too. Investors in a Bear Stearns-issued ETN narrowly escaped the same fate last year when that embattled company was taken over by JP Morgan Chase.

Even scarier, most of the major ETN issuers are not exactly as stable as the Rock of Gibraltar. Far from it. Going back to our Barclays example, BCS stock has been cut in half in just the last month.

Why? Analysts think Barclays is so shaky the U.K. government may have to nationalize it. The company has taken billions in write-downs on the same kind of toxic derivatives that are bringing down other large banks.

Just this week, Moody’s Investor Services downgraded Barclays debt — which includes all the iPath ETNs — to Aa3 from Aa1. Traders reacted by demanding wider bid-ask spreads on iPath ETNs, which means investors owning those ETNs could take a shellacking.

I’m not just picking on Barclays here. All the banks that issue ETNs are having similar problems. Other top ETN issuers include …

• Deutsche Bank (DB)

• Morgan Stanley (MS)

• Goldman Sachs (GS)

• Swedish Export Credit Corp (FUE)

• HSBC Bank (HBC)

Would you loan your money to any of these companies? That’s exactly what you are doing when you buy their ETNs! Yet most of them are so weak they’ve had to be bailed out by the government and/or the Federal Reserve in the last few months.

So …

Am I Saying You Should
Always Avoid ETNs?

No. I believe that they can provide a way to trade in markets that are hard to access otherwise. What I’m saying is that you need to understand the risk you are taking before you buy.

Sadly, many investors have no idea that they are accepting this kind of credit risk when they buy an ETN. They think it is just a new kind of mutual fund. They don’t know they can lose their money even if their market predictions are totally accurate.

What’s even more infuriating is that the ETN issuers don’t always go out of their way to let people know the difference between ETFs and ETNs. Barclays at least had the good sense to market their ETFs and ETNs under two different names: iShares = ETFs; iPath = ETNs.

Other companies leave it up to you to know what you’re buying. You see “PowerShares” in the name and assume you are buying an ETF. Not so — some ETNs carry the PowerShares name.

Nor is it clear which bank is behind which ETN — sometimes it varies even within the same ETN family. So you have to dig through the prospectus to find out exactly who is getting your money.

Even Morningstar, the very pillar of unbiased fund data, lumps ETFs and ETNs into the same category in their database. Worse, they don’t always include “ETN” in the fund names.

What Should You Do?

I suggest avoiding ETNs completely if there is a very similar ETF available. And if you do buy an ETN, make sure you aren’t exposing too much of your portfolio to any one ETN sponsor — and keep an eye on the issuing companies.

Right now there are roughly 87 ETNs available to U.S. investors. I don’t have enough space to list them all here, but I’m giving you a list below that shows some of the larger ones. Refer to this list — and know what you’re buying.

Best wishes,

Ron

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