The development of exchange traded funds (ETFs) has been one of the most important financial innovations for individual investors in recent decades. Essentially, ETFs are open-end investment companies combining the close link between price and NAV of mutual funds with the intraday trading of closed end funds. ETFs are also more tax efficient than CEFs or mutual funds, because capital gains can only accrue after initial purchase. This avoids the "embedded" capital gains at purchase often found in the other two investment vehicles. Furthermore, ETFs often have rock-bottom fees. I have nothing but good things to say about ETFs in general and my favorite ETF provider, Vanguard, in particular: it is quite an opportunity to invest commission-free in the entire U.S. equity market (NYSEARCA:VTI) at an annualized cost of 0.05%.
ETNs: A Different Animal
My opinion of exchange traded notes (ETNs), the lesser-known cousin of ETFs, is less favorable. Like ETFs, they are traded on exchanges throughout the day. But their underlying structure is totally different. Whereas ETFs facilitate direct ownership of an underlying pool of securities, ETNs are senior unsecured debt obligations issued by banks or other investment companies. Unsecured means that there are no underlying assets that belong specifically to the ETN holder. In the event of a bankruptcy, ETN holders are in the same place as any other senior bondholder. An excerpt from the prospectus for the popular iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) clearly spells this out:
Neither the indenture governing the notes nor the warrant indenture or warrant agreement governing the warrants contains any restrictions on our ability or the ability of any of our affiliates to sell, pledge or otherwise convey all or any portion of the securities or other instruments acquired by us or our affiliates. Neither we nor any of our affiliates will pledge or otherwise hold those securities or other instruments for the benefit of holders of the securities. Consequently, in the event of a bankruptcy, insolvency or liquidation involving us, any of those securities or instruments that we own will be subject to the claims of our creditors generally and will not be available specifically for the benefit of the holders of the securities. The principal, interest or any other amounts payable on the notes, and the amount of money or warrant property payable or deliverable in respect of the warrants, constitute our direct, unconditional, unsecured and unsubordinated obligations ranking pari passu, without any preference among themselves, with all our other outstanding unsecured and unsubordinated obligations, present and future, except those obligations as are preferred by operation of law (emphasis added).
So in terms of ownership claims, ETNs are bonds. If there was any remaining ambiguity to this, the prospectus further elaborates how the funds raised by issuing VXX ETNs will be used:
Unless otherwise indicated in the accompanying prospectus supplement, the net proceeds from the offering of the securities will be used to support the development and expansion of our business and to strengthen further our capital base. That development and expansion may occur through the development of existing operations, the establishment of new subsidiaries or acquisitions if suitable opportunities should arise (emphasis added).
What this means is that Barclays Bank PLC (NYSE:BCS) can do whatever it wants with the funds raised by selling VXX, just like with any other corporate bond. And while elsewhere in the prospectus the company states that it may partially hedge the risk of selling VXX (supplement S-131), it makes no guarantees. I do not put much stock in vague intentions, and consider this statement of good faith essentially window dressing.
What makes ETNs different than plain vanilla corporate bonds is that the issuer promises to provide the return profile of some reference basket of securities rather than normal interest payments. For example, the ETRACS 2X Leveraged Long Wells Fargo Business Development Company Index ETN (NYSEARCA:BDCL) promises to provide the return of a levered BDC portfolio, minus expenses. The reference index serves as the basis of the ETN's "indicative value," which is the current cash settlement value of the ETN were it immediately redeemed. As we will see below, ETN redemption is not frictionless, allowing for a major redistribution of risk onto unsuspecting VXX holders.
A Valuation Puzzle
ETNs clearly entail additional risks beyond those contained in ETFs, particularly credit risk. To get a sense of the magnitude and value of this risk, I'll return to the example of Barclays Bank PLC and its popular VXX ETN. Barclays currently has an A+ rating on its long-term debt. Because VXX's final redemption date is 2019 according to the prospectus, I'll consider it for risk purposes to be a long term A-rated zero coupon corporate bond. The current yield on A rated bonds is 2.64%, so investors should be discounting the note so as to realize a 2.64% annualized gain from now until expiration on January 30, 2019. 2.64% annualized compounded for 5.5 years is about 15%, which is a pretty significant discount to the current market value. That discount would have been even bigger in 2009 during the initial issuance when markets were still in turmoil and the final redemption was ten years away.
The problem is that VXX is structured so that it will rarely, if ever, trade at a discount commensurate with its credit risk. The mechanism preventing this discounting is early redemption, whereby VXX holders can redeem lots of 25,000 shares or more for cash corresponding to the indicative value of the underlying index. Barclays of course charges a 0.05% fee for this service. This is clearly a huge arbitrage opportunity for a trader with the financial wherewithal if the notes are ever priced to truly reflect their underlying credit risk.
The result of this arbitrage mechanism is that VXX almost always trades within a few percentage points of the reference index's indicative value. On one hand, this is good for small-time retail investors, because it helps to make sure the ETN's price tracks the underlying index. But on a deeper level, this is a redistribution of risk from Barclays and savvy VXX traders onto unsuspecting retail investors. Barclays wins because it can issue zero coupon bonds without any discounts, essentially securing a zero-interest loan from VXX buyers (not to mention the steep fees it charges). Arbitrageurs win because if VXX starts to trade at discounts commensurate with the risks faced by holders unable to perform the early redemption arbitrage, they can make a quick profit by pushing the price back in line with the indicative value.
I can picture some readers asking themselves this question, especially because ETNs like VXX are usually held only for the short term. Yet as the financial crisis has reminded us, risk can seem trivial for long periods of time until it blows up in your face. VXX and other similar ETNs are portfolio time bombs that may or may not ever explode. The security is structured so that unsophisticated, small-time holders receive an extra dose of credit risk while Barclays and the Big Boys split the gains between themselves. And while I am unsure of the degree to which VXX contributes to systemic instability by fostering the mispricing of credit risk, it is certainly risky at the individual level. This point is especially important for products like VXX, which are marketed as market insurance. It is never a good idea to buy insurance from a company that is 1.) Not required to hold reserves against the policies it writes 2.) Whose going concern risk is highly correlated with the prospect of insurance payoffs (i.e. extreme market events).
The Golden Rule for ETNs
Because of these hidden risks, I propose a two-step golden rule for all retail investors considering purchasing an ETN. First, if your investment opinion can be expressed using an ETF, drop the ETN and go with the ETF. Second, if you are still convinced that an ETN is the way to go, then read the entire prospectus. If you can make a compelling case to yourself that you are not the mark at a rigged poker game, then go for it. By having a clearer sense of how ETNs work, you can protect yourself from unforeseen blowups.