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Dangers Lurk in Exchange-Traded Notes

Investors who buy ETNs enter into an uneven relationship with more sophisticated counterparties who are very willing to take advantage.

Samuel Lee, 06/11/2012

This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

The decision to invest in an exchange-traded note seems to depend 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 given by an investor to an investment bank, with all the risks that entails. In return, the bank promises exposure to an index’s return, minus fees, regardless of how hard it is to actually own the index’s underlying assets. On top of that, many (but not all) ETNs are taxed like stocks, thanks to a quirk in U.S. tax law. These benefits could be a godsend for investors who want entry into less-liquid, tax-unfriendly strategies. As long as investors keep their eyes on credit risk, they can have their cake and eat it, too. At least, that’s the conventional wisdom.

It’s wrong.

ETNs are so much 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 ETFs, ETNs are not registered under the Investment Company Act of 1940, 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 ETNs and ETFs. Where ETN investors should fear what they don’t know, they instead are gulled into thinking that they understand the risks and costs they bear.

The investment banks take full 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 get to pay hefty fees for the privilege of offering this benefit to banks.

And even 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 investors, earning banks fatter margins when their ETNs suddenly drop in value.

Samuel Lee is an ETF Analyst with Morningstar.

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