The Thing About ETNs

| About: iPath MSCI (INP)

By Matthew Hougan

Jim Wiandt's mostly right about ETNs. What matters is how they perform for investors.

Murray Coleman seems to be relaying worries about the motives of the product issuers. Here's the dirty little secret: All product issuers (with the exception of Vanguard) want your money. They want as much of it as they can get.

Do I wish ETNs were cheaper? Yes.

Do I wish banks would lower fees? Yes.

Do I think banks are launching ETNs because the process is cheaper, faster and more efficient than the process of launching ETFs? Yes.

Does that make them "good" or "bad" products? I don't think so.

What matters is how they perform for investors, and to that end, Jim has it right: The big issue is credit risk vs. tracking error (although please read my explanation of ETN tracking performance below, because Jim's got it wrong.).

How Real Is The Credit Risk?

I go back and forth on how important the credit risk is. The risk is tiny. But it's real.

I think anyone who held the BearLinx ETN (BSR) through the Bear Stearns (NYSE:BSC) implosion was either nuts or ignorant. There was significant risk of Bear Stearns going bankrupt. You had zero upside and 100% downside for holding that note.

Then again, it all turned out OK. It usually does. Heck, even Barings Bank made good on its credit promises in the end. You'd need an unprecedented bank failure to lose out on one of these things. But crazy things do happen.

A Point of Clarity on Tracking Error

I want to clear up one thing Jim said that is factually inaccurate. Jim listed "perfect tracking" as the No. 1 benefit of ETNs.

Not true.

ETNs don't guarantee zero tracking error. ETNs guarantee that institutional investors can redeem them at full value on a daily or weekly basis. They will never trade below the value of their index over the long term.

But there's no guarantee they won't trade above their net asset value, and that is an important distinction.

The iPath MSCI India ETN (NYSEARCA:INP) traded at a huge premium to net asset value for many months last year, after the Indian government clamped down on foreign investment. Investors who bought the note when it was trading at a premium have significantly underperformed the index over the past six months as that premium has disappeared.

This is not a technical point. ETNs are focused on illiquid markets. The lesson of the India ETN is that when markets get really illiquid, funny things can happen.

Always check to see if an ETN is trading at a premium to NAV before buying.