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Credit Exposure for ETNs Not Going Away

Ron DeLegge

The intensity of Europe's sovereign debt crisis is showing up in Europe's banking sector. And while the problem may seem to be at a safe distance from U.S. shores, it's a lot closer than many think.

The $15 billion sitting inside U.S. listed exchange-traded notes or 'ETNs' looks especially vulnerable to trouble. Will ETN investors be able to escape Europe's crisis unscathed? 

An Ugly Picture The fourth quarter results for major ETN sponsors shows deep financial problems with Europe's leading banks.

Barclays PLC's (NYSE: BCS - News) 2011 net income sank 16% and during Q4 the company's pretax profits fell to $833 million compared to $2.36 billion for the same period in 2010. Last week, Robert Diamond, the company's CEO, doubted whether Barclays can achieve his goal of 13% return on equity by 2013. He cited 'external headwinds' as the main obstacle.

Credit Suisse AG (NYSE: CS - News) reported a fourth quarter net loss of 637 million francs and took a charge of 981 million francs. Switzerland's second largest bank by assets is still trying to unload risky debt and to restructure its business.

UBS AG (NYSE: UBS - News) reported a 76% decline in Q4 2011 net profits. The company is licking its wounds from $2 billion in losses tied to unauthorized trading by ex-employee Kweku Adoboli. In January, Adoboli pled not guilty to two charges of fraud and two for false accounting while working for Swiss bank

Deutsche Bank AG's (NYSE: DB - News) profit sank 69% in Q4 2011. According to some analysts, DB is behind the curve on raising more capital to comply with new capital requirements for European banks that take effect next year. DB will need to raise between 10 and 20 billion euros.

ETNs vs. ETFs Buying an ETN in this credit environment is akin to hitching your wagon to a sinking star. And although ETNs and exchange-traded funds (ETFs) are sometimes grouped together, or worse, confused as the same thing, they are not.

Unlike traditional ETFs, exchange-traded notes are debt obligations backed by the financial or banking institution that issues them. ETNs pay a return linked to the performance of a single security or index. Who pays the return? The financial issuer backing the note.

ETNs can track a variety of assets from commodities (NYSEArca: DJP - News), to the VIX Index (NYSEArca: VXX - News) and master limited partnerships (NYSEArca: AMJ - News). ETNs are also used as day trading instruments for those that want leveraged long exposure (NYSEArca: DGP - News) or leveraged short (NYSEArca: DZZ - News) to gold or other assets.

Investors that choose to keep their ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. The annual fees deducted reduce the value of the payment. Maturity periods can vary and may be as long as 30 years. ETN investors that don't want to hold their note to maturity can sell it prior to maturity on the exchange where they trade.

Other Complications Another rarely discussed problem with ETNs is that they complicate the asset allocation process that so many financial professionals subscribe to. Asset allocation is the process of dividing up your investments across various categories, like stocks (NYSEArca: VTI - News), bonds (NYSEArca: BND - News), cash, real estate (NYSEArca: ICF - News), and so forth.

But here's how ETNs tricks asset allocators: Even though the investor assumes he has market exposure to precious metals when buying a precious metals ETN like the iPath DJ-UBS Precious Metals ETN (NYSEArca: JJP - News), the investor really has exposure to debt from Barclays Bank (NYSE: BCS - News). What's does it mean? It means the investor has unwittingly increased the fixed income portion of his portfolio's asset allocation to bonds instead of getting the exposure to the precious metals (NYSEArca: GLTR - News) that he wants!

None of the selling points about ETNs - their lack of tracking error or their temporary tax favored status (not currency ETNs) - are compelling enough to overcome their many flaws.

Avoiding the ETN Meltdown Ahead During the 2008-09 Financial Crisis, the ETNs issued by Lehman Brothers eventually became worthless. Today, the $15 billion market for ETNs in the U.S. is much larger than it was four years ago, which means one thing: This time around, the financial damage will be much worse.

ETFguide's ETF Profit Strategy Newsletter provides a short list of the 15 largest U.S. traded ETNs and immediate alternatives that invest in the same categories. One example is the iShares S&P Nifty Fifty ETF (NYSEArca: INDY - News), which can be used in the place of the iPath MSCI India ETN (NYSEArca: INP - News). Listen to the advice of ETN pacifists at your own risk.

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