Reminder: Notes Are Not Funds

This ETFInvestor weekly update was originally sent to subscribers on Jan. 24, 2016. Download a complimentary copy of ETFInvestor here.

Every so often, investors have been served with a not-so-gentle reminder of the perils of investing in exchange-traded notes, or ETNs. The week of Jan. 18, 2016, served us with two such nudges.

First, on Jan. 20,

On that same day, we saw an enormous premium develop in the shares of another ETN. As of the close of trading on Jan. 20, iPath S&P GSCI Crude Oil ETN OIL was priced at $5.51 per share. Its net asset value at day's end was $3.70 per share. This meant that the ETN's shares were trading at a nearly 49% premium to their actual worth. By the time the closing bell rang on Friday, Jan. 22, OIL's shares were priced at $4.83, and its indicative NAV (a real-time estimate of its worth, not an official value) was $4.49. Over the course of two days, the premium withered to a still-troublesome 7.6%. As demand for OIL's shares has surged (its total shares outstanding have increased 32% since mid-November 2015), the note's sponsor

ETNs are often grouped together with exchange-traded funds in casual conversation, but these seemingly close cousins are in reality very distant relatives. Notes are not funds.

Notes are born out of the structured-products desks of investment banks. Bets that had historically been offered in illiquid and difficult-to-access formats are now available in an ETN wrapper to anyone who can plug into the stock exchange. Notes do offer some benefits. First, they are far more liquid than traditional structured products. Second, because they are unsecured debt obligations, they receive more-favorable tax treatment relative to ETFs that invest in corners of the market like commodities and master limited partnerships. Third, well, there is no third.

Banks aren't writing these IOUs out of the goodness of their hearts. Notes give banks access to funds--investors are loaning them money--without having to put up any collateral. Investors are taking on credit risk by investing in an unsecured debt obligation of the issuing bank. Also, most note issuers are collecting big fees. The median expense ratio among the 197 ETNs in Morningstar's database is 0.75%. Furthermore, investors should be aware that some ETNs of older vintages, including OIL, charge path-dependent fees. This means that their rake may actually go up even as their share prices plummet, thus adding insult to injury.

Banks are betting on their terms. As the case of the redemption of the UBS notes shows, banks may opt out if these bets move against them. And as the throttling down of the issuance of new shares of OIL shows, banks can also slow the pace of betting (and often reserve the right to halt it temporarily) at the expense of any poor souls who naively buy shares of these notes at prices far in excess of their true value.

One thing is clear when it comes to ETNs: The house always wins.

Disclosure: Morningstar, Inc.'s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.