Understanding the Risks of Exchange Traded Notes (ETNs)

The beauty of exchange traded funds (ETFs) is that they allow investors to own a basket of various securities. Whether they are bonds, stocks or derivatives, purchasing an ETF enables investors to instantly gain access to a multitude of assets. The problem is—especially in the early days of ETF construction—not all asset classes fit ‘neatly’ in an ETF wrapper.

For example, some sectors or regions of the market feature low liquidity or high barriers to entry. Moreover, some asset classes like commodity futures lend themselves to different tax considerations. In the case of many early commodity futures ETFs, they were taxed and treated as partnerships. That meant getting a dreaded K-1 statement. Others like master limited partnerships (MLPs) have rules dictating just how much a fund can legally hold of the asset class. Pureplay MLP ETFs are actually treated as corporations and lend themselves to double taxation.

To overcome some of these issues, early fund sponsors looked to create a new fund type: the exchange traded note (ETN).

The key difference with ETNs and ETFs is that the notes are literally debt instruments. With an ETN, the fund sponsor promises to pay investors at the maturity date the returns of the fund’s underlying index. But they don’t physically own the asset class. This allowed investors to track things like commodities futures without the tax issues. For example, you could buy iPath S&P GSCI Total Return Index ETN (GSP) over the iShares S&P GSCI Commodity-Indexed Trust ETF (GSG) and get the same exposure without having a K-1 statement.

Don’t forget to check out our Commodities page to explore more mutual funds and ETFs.

The devil is often in the details. In this case, it’s the fact that these are debt instruments. ETNs are considered subordinate debt on the sponsor’s balance sheet, just like any other bond or IOU they might have. You can see how this could be a problem. One of the first issuers of notes, Lehman Brothers, defaulted on its suite of ETNs back in 2008 during the financial crisis. Had J.P. Morgan not purchased Bear Stearns, its suite of ETNs would have also been defaulted on.

Another huge issuer of ETNs was Credit Suisse. While UBS—another major sponsor of ETNs—has stepped up to rescue the bank, the Swiss banking giant hasn’t officially announced what it plans to do with its inherited suite of ETNs. Other major issuers include Barclays and Deutsche Bank.

Aside from this default risk, there are issues with creation. In theory, ETFs are infinite. As long as authorized participants hand over cash and/or securities, new shares of the fund can be created. However, because ETNs are simply promises for a bank to pay, sponsors can only issue so much before they say enough. And this has happened more often than not. For example, the largest ETN—the $2.6 billion JPMorgan Alerian MLP Index ETN (AMJ) —stopped issuing new shares back in 2012.

Finally, ETNs come with a nasty escape clause for the sponsors. They can call the notes long before they mature or, worse, remove them from the major exchanges. Often this happens without notice. For example, Barclays recently announced that it plans to call 21 of its ETNs by the end of the summer. Investors could be stuck holding onto illiquid assets until they are paid out the NAV.

Today, there are only about $11 billion worth of investors’ money tucked inside 125 different ETNs. But those that exist aren’t small fries. The iPath Bloomberg Commodity Index Total Return (DJP) holds more than $600 million, while the ETRACS Alerian MLP Infrastructure Index ETN Series B (MLPB) has more than $200 million.

However, with default risks now growing and sponsors—which are mostly banks—looking to shore up reserves/reduce debt, the fund structure could be under attack. And investors could be at risk.

The simple answer? Sell your ETNs and replace them with the ETF equivalent.

These days, new ETF designs have removed the issues with owning many of the asset classes that ETNs were created for. For instance, iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) offers the same exposure as the previously mentioned GSG, without the K-1. By using it over the GSP ETN, investors avoid the so-called counterparty risk. Meanwhile, the shift in MLPs toward C-corps has left many infrastructure ETFs being able to own the remaining few without regulatory hassles.

While ETFs have garnered plenty of attention, mutual funds and their active management can be a big win for investors as well. For example, the Vanguard Commodity Strategy Fund (VCMDX) has been a good performer, with its active managers finding the best commodity trends.

Ultimately, the ETN experiment could finally be over. The latest banking crisis highlights the risk in the sector and why investors may want to avoid ETNs. Active and passive ETF options—along with some of the classic mutual funds—can might be better options to serve a similar purpose.