ETNs: Market Access Vs. Default Risk

• By Will McClatchy, ETFzone.com
• On 11:30 pm EDT, Saturday October 24, 2009

Exchange Traded Notes have hidden risks not found in standard Exchange Traded Funds, but they have greater flexibility than ETFs and give investors efficient access to niche markets poorly suited to ETFs. Understanding this risk/reward ratio is the key to ETN investing.

ETNs are unsecured debt from their issuer, not direct ownership of stocks, bonds or other assets like ETFs. So if the provider goes bankrupt, investors end up holding the bag. This was the case with Lehman Brothers, whose three ETNs shuttered upon its demise. Their ETN investors wait in line like every other creditor to get compensation but will never recover their original investment.

ETN investors need to be adequately compensated for this extra credit risk. We estimate fair compensation for default risk to be 2 to 5 percentage points of return in most cases.

In return for this extra risk, ETNs provide access to thinly traded commodities futures markets, highly regulated equity markets, or otherwise illiquid markets. The provider of an ETN does not have to enter a futures market all the time to make sure a particular commodity is tracked well. The provider simply has to promise to deliver the underlying index's return. Typically they will obtain exposure to the index with a variety of methods, including private transactions. ETFs do not have this flexibility. Some ETFs using commodities futures attract parasitical traders who jump in front of their pre-announced moves. These ETF returns suffer mightily even though there is no risk of default. Undeperformance over the target index can easily be in the double digits.

This trade-off between ETN and ETF has been described as one of superior tracking (ETNs) vs. superior credit risk (ETFs). But tracking here is not the same as in a typical equities ETF, where poor tracking is simply random variation around a target index. In many niche commodities markets, ETFs not only track poorly but do so consistently for the worse. Superior ETN tracking typically means superior returns.

The upside of these relatively more efficient ETNs can easily exceed the greater risk of default.

Although the appeal of individual ETNs may be great, it goes without saying that such niche areas are for the savvy and focused investor, and that no portfolio should take on more than a modest amount of total ETN exposure from any one provider.

One element in ETNs' favor is that the most reckless players (Bear Stearns, Lehman Brothers) have been driven from the exchange traded investment field. What remains are relatively more stable, conservative players such as Barclays and Deutsche Bank. They are not without their issues, but it is generally safest after the storm.

Barclays, the dominant player in the ETN space, has more experience in institutional indexing than anyone and traditionally has shown a prudent attitude towards risk. Nor does it have a big leveraged portfolio of its own.

Contrast that with Lehman Brothers and other New York investment banks which tried to beat risky markets with exotic derivatives and enormous leverage. (Estimates of Lehman's leverage or exposure to risk vs. equity were reportedly as high as 40:1.) Lehman went down in flames because of a risk-blind culture.

London-based Barclays PLC still is the firm standing behind iPath ETNs (despite the iShares ETF line having been sold to private equity firm Blackrock, Inc.) Probably too big to fail, Barclays was the recipient of a UK government handout. If that had not happened, disaster could have struck iPath investors. It appears that is not likely to happen any time soon, but the possibility is real.

The largest ETN line is Barclays' iPath products whose prospectus warns that:

"...in the event of a bankruptcy, insolvency or liquidation involving us, any of those securities or instruments that we own will be subject to the claims of our creditors generally and will not be available specifically for the benefit of the holders of the notes."

Ratings agencies are normally a good gauge of credit risk, but across the board the major US credit agencies turned a blind eye to risk with investment banks including Lehman. They appear to have been influenced by lucrative consulting income.

In the future, we would hope that all providers secure ETNs with the assets bought with investor proceeds. First and exclusive access to this collateral would go far toward lowering credit risk and would put ETNs back on par with ETFs. The only realistic risk of loss with an ETF is when the value of the underlying asset class itself declines.

For what purpose are these assets commingled with other assets on the balance sheet of a giant financial provider? Why should other creditors be allowed to plunder them? As a matter of fairness, these assets should be kept unencumbered for the benefit of those who bought them.

Footnote on ETF default risk:

Default of an ETF is essentially impossible since these are held in trust to support the creation and eventual redemption of an ETF similar to the way common shares are held for investors in street name at a brokerage firm. Custody is maintained by quasi-governmental agencies, so failure by any single commercial firm will not affect investors.

When the financial crisis hit in 2008, ETFs remained secure. Some wound down for lack of capital or difficulty in obtaining securities, but not one failed to repay investors in full.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.

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