Over the last decade many complex financial instruments have become available to retail investors. Many view this as a good thing, giving the "little guy" greater flexibility and many view it as unwelcome, requiring the "little guy" to acquire an in-depth knowledge base to fully grasp these vehicles.
I'm in the middle, seeing many of these instruments (such as ETFs and options) as a plus and some (such as reverse ETFs and ETNs) too complicated for the average or, maybe, even the above average investor.
I believe ETNs, which, on the surface, seem straightforward, to be, contrarily, quite problematic. I started to write an in depth analysis of these problems and it was looking more like a text-book than an article. So, for purposes of this article, I'll look at it in simplified fashion.
First, let me say that ETNs can offer access to certain markets that are not addressed elsewhere in the investment community, such as commodities, currency and volatility. They also track indexes directly, with no tracking error. This level of precision can be important to the "fine-tuner". I see these as important for the experienced investor and one with the requisite skills and who likely have knowledge of the ETN structure.
On the other hand, most average to above average investors really don't fully understand what an ETN is really all about. I direct this article to them.
Let's say I offered you an investment with the following parameters, would you take it?
1) You loan me money.
2) I put your money in my bank account to be used however I please, whenever I please. Of course your money is subject to my creditors and I could go bankrupt.
3) I give you a promissory note agreeing to return your money, in ten years, adjusted up or down based upon the performance of an index of your choosing (DOW,S&P,MSCI, etc).
4) If you want your money sooner, I may make you an offer, or you can try to sell your promissory note to a third party.
5) I charge you a fee (about 1% per year) for holding your money.
Well, if you are willing to take on this "investment" then you need not read any further, ETNs will not bother you. On the other hand, if such an investment scares you, then you need to look a little deeper into ETNs.
The "N" in ETN stands for NOTE. That means it is a loan to the sponsor. The money you "invest" is not earmarked to any stock, and it is not held in a separate account (unlike mutual funds or ETFs). The plan sponsor may simply engage in various derivative investments to hedge exposure. They need not even do this.
So, first off, you need to be willing to accept the credit worthiness of the borrower, in this case the ETN sponsor. Now, the sponsor bankruptcy risk is small, but I'm reminded of Lehman, Bear Sterns and MF Global. Even some sovereign nations are on the verge of bankruptcy and their "note-holders" are taking a haircut.
Next, let's say the actual risk of sponsor bankruptcy is small. What will happen if the sponsor's credit rating is reduced? Could this depress the value of the ETN shares, indirectly, as it would with any other indenture? If you had an ETN with a sponsor that is being downgraded, would you be willing to take a "haircut" to get out?
In addition to credit risk, is what I call the "Displacement Risk". When investors buy mutual funds, stocks or ETFs they are putting money directly to work in that particular investment and the underlying stocks. This purchase actually helps the share prices to go up, benefiting all shareholders.
In theory, if everyone sold all their individual shares in stocks comprising an index (such as the S&P) and simultaneously reinvested them in a corresponding S&P Index ETF, nothing would change. The ETF would be required to buy an equivalent number of shares. In the end, the ETF holds the shares on behalf of the investors.
This is not how an ETN works. The ETN does not put the money into the investment chosen by the investor (if it happens to, it is doing it for its own account, not yours). As a result the money is "displaced" and does not drive prices up. Unlike a mutual fund or ETF, if investors sell stocks in the underlying index and simultaneously buy an ETN, the money is drawn away from the stocks comprising the index and ends up in the ETN sponsor's "bank account". The likely result is at least a decrease and conceivably, a collapse of the index.
Now, to be completely fair, the ETN sponsor probably hedges. We can't know for sure what they do, as it isn't disclosed, but some form of hedging is reasonable to assume. Depending upon how this "assumed" hedge is structured, it can force some actual money to flow into the stocks underlying the appropriate index. It is a round-about route as it is actually the "counter-party" to the ETN that may buy the underlying stocks.
If, and to what extent any money actually flows into the underlying stocks is anyone's guess. In any event it certainly won't be a one-to-one basis. In the end, any hedging will most likely "follow the trend" and not create it, as money poured into an ETF would. So, though "counter hedging" exists, it is not too helpful to those craving for price appreciation.
The next risk is what I call the "Adverse Party Risk". Money managers of mutual funds, ETFs, wealth accounts, hedge funds etc., can only make money on their asset base. The best way to grow assets is to make solid returns. So, the interests of these sponsors are aligned with the interests of the investor. "We make money...you make money."
This is not necessarily so with an ETN. The ETN sponsor could take a small portion of the money and hedge upside risk, keeping the rest of the money for "whatever". They might even "short" one or more of the component stocks in the index. We remember a recent case where the sponsor actually took positions with their own funds, counter to the product they sold. This is how Wall Street can function.
In these cases, if the ETN's underlying index goes down in share price, the sponsor actually profits by the decline, eventually returning less to the investors than the initial deposit in their "bank account". Since the index is not actively managed, there is no "blame to go around" if the index falls. So, the investor and the sponsor might actually be viewed as adverse parties. "You lose money... we make money."
It is pretty easy for me to understand the stampede by sponsors to roll out new ETNs. Sponsors have grown very adept at managing exotic derivatives and prop trading. ETNs are a nice source of funds. Some day they might even manipulate the stocks in the index down just to profit from the ETN's downward spiral. This risk might even reach greater potential as the maturity date of the note approaches.
The sponsors of ETNs structure their products as ETNs instead of ETFs for a reason. They want your cash and don't want you to dictate how they must use it. Since they can take positions that cause them to keep more of my money, I consider our interest adverse.
No discussion comparing ETFs and ETNs would be complete without discussing the impact of taxes. This is at it's most dramatic when looking at Master Limited Partnership (MLP) ETNs and ETFs.
A MLP ETN, such as AMJ, distributions are taxed at ordinary income rates as interest payments. Distributions from the ETF counterpart, AMLP, on the other hand, is treated as return of capital and then as qualified dividends (and no current tax burden at all on some distributions). Inasmuch as a significant portion of the total return of MLPs can come from distributions, the favorable tax treatment for ETFs relative to ETNs can be considerable. This is magnified for the "buy and hold" investor.
When the MLP market is flat, and return is measured mostly by distributions, the ETF should outperform the ETN as a result of the tax treatment of distributions. When the market is down, the ETF should also perform better for the same reason. In a rising market, when the return is a result of share price appreciation, not so much distributions, ETNs have the edge as share price appreciation is at the more favorable capital gains rates
Conclusion: Individually and collectively, these reasons are enough to steer me completely away from ETNs. I always like to remind myself that risk isn't important, until it is. There are enough ETFs, stocks, options, etc. keeping my plate full. I don't need to voluntarily take on unnecessary and added risk.
What further concerns me is that many "marketers" are starting to replace the acronyms for ETNs and ETFs with the "catch-all" ETP (Exchange Traded Product). This obfuscates the particular product being marketed. As a result, many investors will just assume that they are all similar or not take the time to properly research which type of ETP they are actually getting.
The investment world seems happy with "caveat emptor". Me, not so much.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.