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ETF Specialist

Exchange-Traded Notes Are Worse Than You Think

On the perils of dealing with vastly more sophisticated counterparties.

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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.

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