The Real Problem with ETNs: The Spreads

| About: iPath GEMS (JEM)

By Dave Nadig

It’s one thing to love a product for its innovation, but another to blanket the world with that love without highlighting the real problems.

Paul did a great job covering the credit risk, although I tend to side more with Matt Hougan on that part of the argument. But my real problem with ETNs is trading them.

We can argue about chicken/egg all you like, but the reality is this: The very most interesting ETNs, the ones that would be tough to deliver in an ETF package, are the ones with the worst trading problems. Right now, the top of the league table in “holy cow, look at the spreads” is dominated by ETNs.

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The reasons for this are simple: While it’s true that an Authorized Participant can roll up 50,000 shares of any ETN (at least the iPath ETNs) and turn those in for cash at NAV, that AP has to go get those shares from somewhere. When the trading volume plummets, that means it’ll be tough to get on the open market. To make matters worse, most of the fun ETNs are interesting precisely because their underlying markets (individual industrial metals, carbon credits, emerging market currencies, etc.) are difficult to get at.

The real reason these products trade so poorly is that they are truly forgotten. I don’t care how much you love them, Matt; when you can’t even find the documents for the Barclays GEMS Index ETN (NYSE: JEM) anymore (unless you go hunting at the SEC), how are investors supposed to have any confidence? There’s no arb mechanism in place to keep JEM near its index value, because nobody in their right mind is going to put on a 15-way currency forward contract in order to offset the risk of handing someone their ETN shares. Instead, JEM will simply trade all over the place until it finally, blissfully expires in 2038, or until Barclays Capital decides to put it out of its misery.

And this is a product that was launched just 20 months ago. Let’s be clear: With the note issued, and the full value of that note presumably hedged on a ledger somewhere in London, there is zero incentive for Barclays to ever pay attention to JEM again. Instead, they can just happily collect their 89 basis points until it trades itself into the ground. With just over $3 million left in the notes, that’s not much money―about $30,000 by my HP 12c. But that may be more money than it would cost in lawyers’ fees to actually shut the thing down.

I don’t mean to pick on Barclays―every issuer has their great products and their forgotten ones. I could make the same case for virtually all the ETN issuers. With most ETF products (with a few notable exceptions in illiquid asset classes), investors can be reasonably sure that if they exercise some basic common sense, they can get in and out of smaller ETFs, because the arbitrage mechanism for even the craziest one-off U.S. equity idea will still work.

These particular forgotten stepchildren, though, are land mines for the unwary.

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