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Exchange-Traded Notes Are Worse Than You Think

On the perils of dealing with vastly more sophisticated counterparties.

Samuel Lee, 03/21/2012

Conventional wisdom holds that the decision to invest in an exchange-traded note depends on a straightforward calculus, the trade-off between credit risk and the ETN's tracking and tax benefits. Unlike an exchange-traded fund, an ETN is essentially an uncollateralized loan to an investment bank, with all the risks that entails. On the other hand, the banks promise exposure to an index's return, minus fees, regardless of how hard it is to own the index's underlying assets. On top of that, many (but not all) ETNs are taxed like stocks, regardless of the ETN's true exposure, thanks to a quirk in U.S. tax law. These benefits could be a godsend for a hard-to-implement, tax-unfriendly strategy owning, say, illiquid, high-yield micro-caps. Conventional wisdom suggests that as long as you keep an eye on credit risk, you can have your cake and eat it, too.

It's wrong. ETNs are more dangerous than that. They are one of the easiest ways individual investors and advisors unwittingly enter into adversarial relationships with vastly more sophisticated investment banks. Unlike mutual funds and most exchange-traded funds, ETNs are not registered under the Investment Company Act of 1940, or the '40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures. ETNs, on the other hand, are weakly standardized contracts, presumably between two sophisticated parties. Yet many investors conflate the two. Where an ETN investor should fear what he doesn't know, he instead is gulled into thinking he understands the risks and costs he bears.

The investment banks take advantage of their superior sophistication. From the get-go, the ETN is a fantastic deal for banks. It's in the DNA of the product; once held, an ETN almost can't help but be fabulously profitable to its issuer. Why? They're dirt-cheap to run because the fixed costs are already borne by infrastructure set up for structured products desks. They're an extremely cheap source of funding, the life blood of the modern bank. More important, this funding becomes more valuable the bleaker an investment bank's health. As a cherry on top, investors pay hefty fees for the privilege of offering this benefit. This isn't enough for some issuers. They've inserted egregious features in the terms of many ETNs. The worst we've identified so far is a fee calculation that secretly shifts even more risk to the investor, earning banks fatter margins when their ETNs suddenly drop in value.

Kicking You When You're Down
The first ETNs, iPath DJ-UBS Commodity Index DJP and iPath S&P GSCI Total Return Index GSP, set a disturbing standard: path-dependent fees, which create tracking error to the index depending on the index's path. In contrast, mutual funds charge path-indifferent fees, which result in a constant percentage gap between an index fund and its benchmark. To see the difference, let's look at how fees contribute to tracking error of the Vanguard 500 Index VFINX.

Below is a chart of the daily percentage difference between the fund and the S&P 500, its benchmark, in 2011. It's nearly a straight line, showing that each day the fund lagged the S&P 500 by roughly an equal amount. Starting from zero at the beginning of the year, it ended the year a little over 0.14%--a hair under VFINX's stated expense ratio of 0.17%. Like many Vanguard index funds, it lagged by less than its fees due to income-generating opportunities such as securities lending and futures arbitrage.


Source: Morningstar Analysts

Compare that with DJP's cumulative tracking-error chart over the same period. This chart is based on DJP's indicative value (the ETN analog of the net asset value). If DJP's annual "investor fee" of 0.75% behaved like an expense ratio, we'd see a smooth, upward-trending line terminating at 0.75%. Instead, DJP lagged its benchmark by 1.27%! Note how DJP's fees spiked most when the commodity index dropped the hardest, during the tumultuous fourth quarter.


Source: Morningstar Analysts

Samuel Lee is an ETF Analyst with Morningstar.
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