For the most part, ETFs and ETNs are similar. Both offer investors basket exposure to a particular asset class and they can each trade on the open market throughout the day.
However, there is one distinction between the two that investors should always be aware of; credit risk. ETFs have no credit risk and the issuing institution is really of little to no importance to an individual investor. The opposite can be said for ETNs, as these securities are debt instruments of the underlying institution, generally senior unsecured notes (read ETF Investors: Beware the Coming ETN Backlash).
This means that an ETN doesn’t actually hold any securities, and instead just offers to pay investors a return equal to an underlying benchmark. While this eliminates tracking error, it does expose investors to the credit risk of the issuing institution. If this firm goes belly up, ETN investors may not be made whole, a situation that cannot happen when dealing with Exchange-Traded Funds.
Usually, this problem isn’t really much of a concern and it should be more-or-less put out of investors’ minds for the most part. Yet with that being said, investors should remember this ETN issue when looking at any of the iPath ETNs thanks to Barclays’ ongoing LIBOR scandal.
This ongoing controversy stems from accusations that Barclays has been engaged in a scheme to alter the London InterBank Offered Rate, popularly known as LIBOR. While the details of the scandal are still being flushed out, it now appears that the government of Great Britain encouraged Barclays —who often had a high LIBOR rate—to nudge its rate lower in order to keep funding costs low and make it appear that the banking system was healthier than it actually was.
It is also important to note that Barclays doesn’t appear to be the only one engaged in the scam and that many more banks could be involved by the time the full details of the scandal are released. Instead, Barclays could just either be the current focus of the scandal or the tip of the iceberg on something much bigger (see The Five Best ETFs over the Past Five Years).
Already, Barclays has been forced to pay a fine of nearly half a billion dollars while its CEO has resigned as well. Some analysts are also forecasting that the firm may also be very risk averse once its next CEO steps into the role, while a breakup of the bank cannot be ruled out as a direct repercussion of the LIBRO fixing scandal.
Thanks to these issues, many credit rating organizations have rethought their position on Barclays. While a major downgrade hasn’t come yet, many of the agencies have slashed their outlooks, suggesting that a downgrade could be in the cards in the near future, especially if more fines or turmoil hits the global bank.
While it is important to note that the bank is not in any immediate danger, a further expansion of penalties or a breakup of the bank into smaller units could have a negative impact on the firm’s credit rating, and force some investors to pause before buying up any of the company’s ETNs.
This is because, as we stated earlier, an ETN carries the credit risk of the underlying institution, unlike their ETF counterparts. So, if Barclays continues to face issues—and especially if they look to become severe—some could start to waver on investing in Barclays debt instruments, including the company’s iPath ETNs.
In fact, currently Barclays is the issuer behind ETNs which account for nearly $6.9 billion in AUM combined. This makes the bank a major player in the ETN world and one of the most in focus companies for its credit risks (read ETFs vs. ETNs: What’s The Difference?).
While most of their notes are somewhat unpopular, there are a few that have accumulated a decent amount of assets. Below, we highlight a few of the company’s most popular notes as well as some ETF alternatives for investors to pick from instead.
Once again, Barclays will most likely be fine, but for those looking to limit risks as much as possible, an ETF approach could be the way to go until this storm blows over. Until then, a good proxy for worries on the issue could be a look to the premium/discount on iPath’s ETNs.
If a big discount appears, suggesting that the product is trading less than its NAV, it could imply that worries are beginning to creep up on Barclays and its credit worthiness. As of right now, this isn’t a problem, but investors should look for this ‘canary in the coalmine’ in regards to the following three Barclays ETNs as the scandal continues to unfold:
iPath Dow Jones UBS Commodity ETN (DJP)
This product is easily the most popular in the iPath lineup having amassed over $2 billion in AUM. The product targets the broad commodity market and is currently trading at a slight discount to NAV. However, it is still within an acceptable range, so investors shouldn’t be concerned at this point in time (read USAG In Focus As Agricultural Commodity ETFs Soar).
As a liquid ETF alternative, investors could look to the PowerShares DB Commodity Index Tracking Fund (DBC). This product has close to $5.7 billion in assets and does not have any of the same credit issues that DJP is suffering from, making it a potential replacement. However, investors should remember that these products in the commodity space are structured as partnerships so a K-1 may be necessary instead at tax time.
iPath S&P 500 VIX Short-Term Futures ETN (VXX)
For a play on broad market volatility, VXX is currently the most popular choice in the market today. The product usually does volume of about 42 million shares and has AUM of about $1.7 billion (see Inside The Barclays S&P VEQTOR ETN).
While the ETF alternative segment is thin in the volatility world, investors still have the ProShares VIX Short-Term Futures ETF (VIXY). This product has a decent volume and asset base, although it is nowhere near what investors see in VXX. Yet, it does get rid of the credit risk issues since it does have an ETF structure.
iPath S&P GSCI Crude Oil TR Index ETN (OIL)
This product from iPath is actually trading at a slight premium to NAV at last look, suggesting that worries aren’t very high for this note (at least for now). Much like the other two on the list, this one is very popular, trading more than 770,000 shares a day while possessing more than $430 million in AUM (read Three ETFs for the Unconventional Oil Revolution).
In terms of ETF alternatives, there are a few in the oil space. Easily the most popular is the United States Oil Fund (USO). This product has more than $1.2 billion in AUM and does exceptional volume that is approaching 8.5 million shares in a day. Much like in the case of DBC, USO is structured as a partnership, meaning that a K-1 will be necessary come tax time although credit risk is zero in the fund.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>
Follow @Eric Dutram on Twitter