ETNs: Flexibility to Fill Gaps

ETFZone

Exchange Traded Notes invest in less liquid securities than Exchange Traded Funds, and this flexibility allows ETNs to serve certain niche asset classes more effectively. The price for this efficiency is a small but real potential for default.ETNs tend to hold unsecured private debt (hence the term notes) backed only by the creditworthiness of their issuer. There is little direct ownership of stocks, bonds or other assets as found in most ETFs. So if the provider goes bankrupt, investors are out of luck. Such was the case with three Lehman Brothers' ETNs which got sucked into bankruptcy. Investors are waiting in line like every other creditor to get compensation and unlikely to get all their principal back.ETN investors are typically compensated for this extra credit risk, and we estimate fair compensation at 2 to 5 additional percentage points, depending on the issuer and the overall economic climate.This extra flexibility can bring substantial efficiencies. A classic example is commodities, where ETFs have suffered serious setbacks trying to roll over short-term futures contract. Parasitical traders have jumped in front of these predictable sell-and-buy patterns, causing double digit annual underperformance. ETNs, in contrast, are free to negotiate private futures or options contracts with mining firms or traders and avoid becoming a target.The greater efficiency of ETNs can easily exceed their greater risk of default. Still, ETNs are for a more sophisticated investor, because the investor must assess the default risk and also because ETNs tend to serve niche asset classes requiring specialized knowledge.One element now in ETNs' favor is that the most reckless, highly leveraged players (Bear Stearns, Lehman Brothers) have been driven from the field. Estimates of Lehman's leverage or exposure to risk vs. equity were reportedly as high as 40:1. What remains are relatively more stable, conservative players such as Barclays and Deutsche Bank.London-based Barclays PLC, which stands behind the major iPath line of ETNs (despite the iShares ETF line having been sold to private equity firm Blackrock, Inc.), was the recipient of a UK government handout which helped bail out iPath investors. The iPath 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 such as Lehman out of fear of losing lucrative consulting income.Providers ought to better 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 where risk of loss with an ETF comes only when the value of the underlying asset class itself declines, not the vehicle itself. In addition, the provider can also back the ETN with their full faith and credit.(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. When the financial crisis hit in 2008, ETFs did not even flinch as an investment vehicle.)The following is a list of nearly 100 ETNs trading today:

  • (NYSEArca:Barclays Asian and Gulf Currency Revaluation ETN), fees of 0.89%
  • (NYSEArca:Barclays GEMS Asia 8 ETN), fees of 0.89%
  • (AMEX:Barclays GEMS ETN), fees of 0.52%
  • (NYSEArca:Bear Stearns BearLinx Alerian MLP Select ETN), fees of 0.85%
  • (NYSEArca:Claymore CEF Index-Linked GS Connect ETN), fees of 0.95%
  • (NYSEArca:Deutsche Bank Agriculture Double Long ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Agriculture Double Short ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Agriculture Long ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Agriculture Short ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Commodity Double Long ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Commodity Double Short ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Commodity Long ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Commodity Short ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Gold Double Long ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Gold Double Short ETN), fees of 0.75%
  • (NYSEArca:Deutsche Bank Gold Short ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS Australian Dollar ETN), fees of 0.4%
  • (NYSEArca:ELEMENTS Benjamin Graham Large Cap Value Total Return ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS Benjamin Graham Small Cap Value Total Return ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS Benjamin Graham Total Market Value Total Return ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS British Pound - GBP/USD ETN), fees of 0.4%
  • (NYSEArca:ELEMENTS Canadian Dollar - CAD/USD ETN), fees of 0.4%
  • (NYSEArca:ELEMENTS Dogs Of The Dow ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS EUR/USD ETN), fees of 0.4%
  • (AMEX:ELEMENTS MLCX Biofuels ETN), fees of 0.75%
  • (AMEX:ELEMENTS MLCX Grains ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS Morningstar Wide Moat Focus ETN), fees of 0.75%
  • (AMEX:ELEMENTS Rogers International Commodity Agriculture ETN), fees of 0.75%
  • (AMEX:ELEMENTS Rogers International Commodity Energy ETN), fees of 0.75%
  • (AMEX:ELEMENTS Rogers International Commodity ETN), fees of 0.75%
  • (AMEX:ELEMENTS Rogers International Commodity Metal ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS S&P Commodity Trends Indicator Total Return ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS SPECTRUM Large Cap US Sector ETN), fees of 0.75%
  • (NYSEArca:ELEMENTS Swiss Franc ETN), fees of 0.4%
  • (AMEX:First Trust KEYnotes ETN), fees of 0.95%
  • (AMEX:iPath CBOE S&P 500 BuyWrite ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Agriculture Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Commodity Total Return ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Copper Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Energy Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Grains Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Industrial Metals Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Livestock Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Natural Gas Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones AIG Nickel Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Aluminum Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Cocoa Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Coffee Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Lead Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Platinum Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Precious Metals Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Softs Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Sugar Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath Dow Jones-AIG Tin Total Return Sub-Index ETN), fees of 0.75%
  • (NYSEArca:iPath EUR/USD Exchange Rate ETN), fees of 0.4%
  • (NYSEArca:iPath GBP/USD Exchange Rate ETN), fees of 0.4%
  • (NYSEArca:iPath Global Carbon ETN), fees of 0.75%
  • (NYSEArca:iPath JPY/USD Exchange Rate ETN), fees of 0.4%
  • (NYSEArca:iPath MSCI India ETN), fees of 0.89%
  • (NYSEArca:iPath Optimized Currency Carry ETN), fees of 0.22%
  • (NYSEArca:iPath S&P 500 VIX Mid-Term Futures ETN), fees of 0.89%
  • (NYSEArca:iPath S&P 500 VIX Short-Term Futures ETN), fees of 0.89%
  • (NYSEArca:iPath S&P GSCI Total Return ETN), fees of 0.75%
  • (NYSEArca:iPath Service Mark S&P GSCI Crude Oil Total Return ETN), fees of 0.75%
  • (NasdaqGM:iShares MSCI All Country Asia ex Japan ETN), fees of 0.74%
  • (NYSEArca:Market Vectors-Indian Rupee/USD ETN), fees of 0.55%
  • (NYSEArca:PowerShares Active U.S. Real Estate ETN), fees of 0.8%
  • (NYSEArca:PowerShares DB Base Metals Double Long ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Base Metals Double Short ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Base Metals Double Short ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Base Metals Short ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Crude Oil Double Short ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Crude Oil Long ETN), fees of 0.75%
  • (NYSEArca:PowerShares DB Crude Oil Short ETN), fees of 0.75%
  • (NYSEArca:UBS E-TRACS CMCI Agriculture Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Energy Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Food Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Gold Total Return ETN), fees of 0.3%
  • (NYSEArca:UBS E-TRACS CMCI Industrial Metals Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Livestock Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Long Platinum Total Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Short Platinum Excess Return ETN), fees of 0.65%
  • (NYSEArca:UBS E-TRACS CMCI Silver Total Return ETN), fees of 0.4%
  • (NYSEArca:UBS E-TRACS CMCI Total Return ETN), fees of 0.65%
  • (NYSEArca:United States Brent Oil Fund LP), fees of 1.26%
  • (NYSEArca:Van Eck Market Vectors Chinese Renminbi/USD ETN), fees of 0.55%
  • (NYSEArca:Van Eck Market Vectors Morgan Stanley Double Long Euro ETN), fees of 0.65%
  • (NYSEArca:Van Eck Market Vectors Morgan Stanley Double Short Euro ETN), fees of 0.65%
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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