The Only Thing Wrong with ETNs

By Jim Wiandt

Murray Coleman emailed me yesterday with a bit of a rambling rant about ETNs, citing higher TERs, and the gimmicky nature of ETNs. You still focus (in a pretty decent blog post) on the marketing aspects, double counting by firms and the facts that ETFs can do anything ETNs can. As an investor, I really don't care about all of that. All I really care about is the pudding. And for me the pudding is 1) Does the vehicle deliver the asset class 2) How is the tracking 3) What are the expenses 4) Are there any risks in the product structure.

That's really all I care about. And if the fund company wants to try to sell the product using dancing cats that are smoking cigarettes, I really could care less.

So first, let's take a clear-eyed look at the positives and negatives of ETNs.

Positives:

1. Perfect tracking
2. Institutional scale/state of the art
3. Cleaner structure from an investor standpoint
4. Possible tax advantages
5. Access to investment areas that might otherwise be impossible to invest in (Murray is wrong that ETNs don't better open up less liquid asset classes for tradeable funds).

Negatives

1. Credit risk
2. Lack of transparency in what is going on with the underlying (notes)
3. Lack of direct ownership in underlying securities (if by that we mean what the notes are trying to track)

Really, those 3 negatives only come down to ONE thing. It is the ONLY thing really wrong with the note structure. That is the credit risk associated with the issuer of the notes that underly the funds. Just one itsy bitsy teensy weensy issue. But it is a doozy.

In so many ways I love notes, and I'm fullly aware that large institution have trusted in them and gotten tremendous scale and tracking benefits from them over the years. But the fact of the matter is that the structure leaves itself open to possible abuse, on the margins or wholesale. Because what's happening is that the fund is taking my money, a large institution is writing notes giving me a guarantee of a certain index's return, and then, well who knows what is going on after that with the note issuer? Think of it as sort of when you give your money to a bank that pays you interest rates, but then there is a wide array of things they can do to MAKE money off of YOUR money. Only this form comes without government insurance.

And there is little question that Murray's point about the appeal of the products to investment banks has to do with the fact that they can sort of double dip, getting paid an ER on the funds, and getting paid by the fund for writing the notes. So how do they do that (build in some extra cost) and still deliver perfect tracking? There's obviously a little extra risk built in there somewhere for someone. Generally, it will fall on the bank, until the bank falls. Do I think Barclays Capital has it covered? Well, yeah. But even with them, there IS a small risk. And more importantly, where do we draw the line on how secure the issuer of the notes has to be.

It's just a can of worms. And the bigger these things get on the retail level, the more the SEC is going to have to look into, and potentially regulate, how the notes themselves are covered. I would love to see this debate opened up, so let's see your comments...and I've got another roundtable for you Matt Hougan - an ETN v ETF debate with the most knowledgeable people on either side.

One thing is clear, ETNs are a VERY different creature form ETFs, not just a marketing gimmick. Accordingly we need to do a better job covering (and differentiating) them on Index Universe, in the wider financial media, and in the industry.

Comments

[adan]

i hope you do follow up re etf's vs etn's, and their differences

thank you much

[huangthomas]

It is almost certain that Chinese Yuan will appreciate against US$. I don't think there is any question about it. If you invest in CNY, you don't want credit worthiness of Morgan Stanley to be in the way between you and Chinese Yuan.

[mangy cat]

ami i glad somebody has actually picked up the possibility that sometime during the next generation ubs, barclays or lehman (even the swedish export credit bank) may fold, a "minor" detail among much b.s on the relative merits of the agricultural commodity etns

[mangy cat]

"b.s. on agricultural commodity etns"
how fitting!

[hh 08]

No one ever mentions that you cannot trade options on ETNs, lacking flexibility and leverage

[sbenard]

You've covered the differences and potential risks quite well. Personally, for my money, the differences are negligible. I would accept the very small credit risk for the tax advantages of an ETN. However, in an IRA, I wouldn't accept that risk.