ETFs Vs. ETNs; You Better be Careful

I recently returned from Singapore, where I participated in the Asia Indexing Conference. My Day 1 role was presenting to my Asian peers the difference between an Exchange Traded Fund (ETF) and an Exchange Traded Note (ETN).

We hear a lot today about ETFs. ETFs are certainly great products that reduce company risk and allow for superior diversification. I want to discuss the ETF’s Cousin, Exchange Traded Notes. Both ETFs and ETNs track an assigned index, trade like a stock and are very liquid. The similarities stop there.

ETFs are structured such that the shareholder owns a basket of securities. Should the ETF provider go bankrupt or shutdown the ETF, the shareholder will usually recieve cash for the market value of the basket of securities. If you own more than 50,000 shares, then you could request to take distribution of the securities.

ETNs are debt instruments. Debt instruments do not own anything but a promise to track an index. The largest ETN based on assets is Barclay’s iPath Dow Jones Commodity Index (DJP). From iPath’s website, we see DJP’s largest holdings are 30% energy, 21% grains, 19% industrial metals, 12% precious metals, 2% livestock and 16% other. At first glance, it would appear that you own commodities with this allocation. However, this allocation is used only as a measure for performance. An investor does not own any commodities, only a promise from Barclays to pay an investor the theoretical allocation of the commodity index. If an ETN provider should go bankrupt, the investor will not receive his or her investment back. Why? Because an ETN is considered an unsecured debt instrument.

An example of this is the recent Lehman Brothers failed ETNs. The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment. Shortly after Lehman’s collapse, Bear Stearn’s ETN holders were hours from the same fate, when JP Morgan stepped in an purchased the company.

Currently the top three ETNs based on assets are:

1. Barclays iPath Dow Jones AIG Commodity Index (DJP)

2. Powershares DB Crude Oil Double Long (DXO)

3. Barclays iPath S&P GSCI Crude Oil (OIL)

When purchasing an ETN, it is a good idea to ask yourself if you would lend money to the ETN provider. After all, ETNs are only a promise to pay, which is unsecured. One simple way to observe the risk of investing in an ETN is to look at the provider’s credit rating. On December 19th, 2008, CNBC showed Morgan Stanley, Goldman Sachs and HSBC with an A S&P rating. Barclay’s has a AA rating.

The credit rating is only a birds eye view (if that). For example, Barclay’s may have a AA rating, but recently the bank was speculated to become state owned because of its poor condition. We have seen the results of an ETN bankruptcy, but not a government takeover. My guess would be that the ETN would continue operating, but this market has been full of surprises.

So, now that you are scared of ETNs, why would you invest in an ETN? Access to certain markets or indexes can be difficult to manage from direct investing. An example of this would be an advisor who decided to invest directly into commodities. If he made a misstep, his client could end up taking delivery of the actual barrels of oil or herds of cattle. This would certainly not be adding value to the relationship, especially of the client lived in the city!

The structure of an ETN gives it great flexibility. This flexibility gives ETNs the ability to track the performance of commodities, countries with limited access, gold, volatility indexes, buy write strategies and currency. The cost of actually implementing these strategies through an ETF structure could be very expensive and have a wide tracking error. The ETN format allows perfect index tracking as long as the provider keeps their promise.

Always know what you are investing in..

Casey Smith – president/owner Wiser Wealth Management, Inc

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