As with corporate bonds, ETNs carry "credit risk"—the risk that the issuing bank will default on the note. If it does, the ETN holder could lose some or all of her investment. Several Lehman Brothers ETNs went up in smoke when the firm failed in 2008.
Another shared characteristic with bonds: liquidity risk—meaning that in some market conditions, you could have trouble finding a buyer. (In certain market circumstances, the issuer might even delist the note.) Issuers can sometimes suspend "unit creation," effectively making the ETN a closed-end vehicle. When the supply of units is fixed, demand can send the market price way above its "indicative" value—the intraday estimate of net asset value.
The risk for the investor is that you buy when the share price is elevated for one of these reasons, then the price drops back to something like indicative value. "You can see a 50 percent premium and a 50 percent drop in a day," says Tom Roseen, head of research services for Lipper.
The Financial Industry Regulatory Authority issued an investor alert in July after an unnamed ETN—widely presumed to be the VelocityShares Daily 2x VIX Short-Term ETN (TVIX)—suspended unit creation in February. The notes developed huge premiums to their indicative value, then plunged when Credit Suisse resumed issuance.
Also like corporate debt issues, some ETNs are callable, meaning the issuer can redeem them before the stated maturity date. If that happens when the market price is less than what you paid, you lose.
There are also potential conflicts of interest between ETN holders and ETN issuers. The issuer, for example, could sell short (or bet against) the assets represented by the note. In theory, the prospectus will warn you of potential conflicts, but some doubt you can rely on that for protection. "I would not say that [conflicts] are very common," says Stevens. "But there's really not much way for [investors] to know. Most of these big banks, if they're doing any kind of trading on their own, it's very proprietary. It's not something the public or even traders are typically going to know about."
Something else that could be buried in the prospectus: real expenses. Lipper says ETN prospectus expense ratios average 0.83 percent, compared with 0.57 percent for ETFs. But that's just the headline fee. Wading through many dense pages of prospectus language—something almost no investor does—can reveal that investors might also pay an "accrued holding rate," an "accrued adjustment factor," an "index-calculation fee" and other types of obscure levies.
Disclosure can be so opaque because ETNs are not regulated by the Investment Company Act of 1940—the backbone of investor protection in the United States. Indeed, when you buy an ETN, you are not so much an investor as a counterparty in a severely lopsided relationship: you on one side and a highly sophisticated investment bank, typically, on the other. As Morningstar's Samuel Lee has written, the bank can pull all sorts of tricks that the average investor has little way to anticipate. The worst, writes Lee, are "path-dependent" fees that can actually create tracking error and cost ETN holders a bundle.
You can find that sort of thing if you're a sophisticated investor with a prospectus and lots of patience, but that is probably not a description of your average investor. "I do this for a living, and reading through these prospectuses takes me a while," says Lee. "It's a long slog. It's basically a math book written by a law professor."