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ETF Specialist

ETN Credit Risk Rears Its Ugly Head

Lehman's bankruptcy sparks renewed caution with ETNs.

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 Lehman Brothers(LEH) bankruptcy this week had ramifications on the exchange-traded product universe besides its impact on financial exchange-traded funds. Most notably, the company's defaulting on its debt included defaults on the three exchange-traded notes that it sponsored: Opta Lehman Commodity Pure Beta ETN (RAW), Opta Lehman Commodity Pure Beta Agriculture ETN  (EOH), and Opta S&P Listed Private Equity ETN  (PPE). Judging by the lack of trading in these securities at the very end, we are assuming that most investors exited these funds before Lehman went under and the $14.5 million (as of Aug. 31) in these funds was mainly the original seed money from the firm and/or the specialist if there was a third party involved.

Even though it would appear that most investors escaped with minimal damage, the speed of the deterioration and the speed at which other institutions continue to stumble is worth noting. As a reminder, ETNs are essentially promissory notes from the sponsoring institution that carry credit risk, no matter the issuer. Two weeks ago, this may have seemed like an afterthought to most investors, but Lehman's stumble highlights the real risks involved in these instruments. ETNs still contain some advantages in terms of taxation (especially with commodities--at least until the IRS says otherwise) and are better for tracking indexes that are harder to physically replicate. Still, if faced with a choice between an ETF and an ETN that track the exact same indexes and have similar costs, we would recommend that investors choose the ETF because it doesn't carry the credit risk at all. 

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Scott Burns does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.