Over the past 20 years, investors who were once trapped in the cumbersome, relatively expensive vehicle that is the mutual fund have moved in droves to the more flexible realm of the exchange-traded fund, which features lower expenses and intraday trading. But ETFs come with certain drawbacks, such as taxable distributions and "tracking error"—discrepancies between a fund's value and its underlying index.
One solution to those problems is the ETN, or exchange-traded note, a relatively new product that combines characteristics of bonds and ETFs. It offers intraday trading, is theoretically immune to tracking error, and provides access to asset classes that are otherwise difficult for average investors to buy.
But ETNs also come with a different set of risks, not the least of which is complexity that can make them inappropriate for anyone who's not a fairly sophisticated investor.
The most important difference between ETNs and ETFs is what they represent. An ETF, like a mutual fund, holds a basket of securities that the ETF holder, of course, owns indirectly. When you buy an ETN, by contrast, you are not buying a bundle of securities; you are lending money to the bank that issues the ETN, and your loan is unsecured. It's an elaborate IOU.
Unlike conventional loans, though, ETNs do not pay periodic interest. Instead, the issuing bank promises to pay you on a maturity date (generally 15 to 30 years out) the return of a benchmark index, minus fees.
The first ETN was offered by Barclays in 2006, launching what has become the iPath family of ETNs investing in everything from commodities to currencies. Today, Lipper counts 212 ETNs, only about half of which reported fund values as of July 31. That figure totaled $14.2 billion, so even if the true total is twice that, ETNs represent a small fraction of the $1.2 trillion held in exchange-traded products, most of that in ETFs.
So why would you want to buy an ETN at all? They offer a certain predictability—as long as the issuer stays afloat. Whereas an ETF represents a pool of securities whose value can be all over the place while you own it, an ETN is simply a promise to pay you the value of an index at some future date.
"The investor is not going to outperform the index in an ETN," says Garrett Stevens, CEO of Exchange Traded Concepts, which helps financial institutions bring ETFs to market. "That's not the goal in an ETN. The goal in an ETN—and in an ETF, for that matter—is to do exactly what the index is doing, not better or worse."
Stevens means passive ETFs. There are active ETFs that do try to beat their indexes, and like any active mutual fund, they can either outperform or underperform the index. By contrast, says Stevens, "when you buy an ETN, you know what you're getting. An ETN is a contractual obligation to pay what this index is doing, less the management fee."
Another benefit: access to assets not normally available to the average investor, like foreign equities, currencies, and, mainly, commodities. Examples run the gamut from the iPath Pure Beta Coffee ETN (symbol: CAFE) to the Velocity Shares 2x Inverse Platinum ETN (IPLT). The principle is the same. In a corn ETN, says Stevens, "you're going to do whatever corn does, minus the management fee, and you know that going into it."
Most observers agree that ETNs offer a tax advantage, in that there are no periodic income or capital distributions, and gains are treated as capital gains, which can carry a low 15 percent federal tax rate for holdings of more than one year. Warning: That seems to be more a matter of informal agreement than anything else. The IRS and Treasury are reconsidering the way ETNs are taxed (check your prospectus).
Of course, there are risks. The most obvious is market risk: The underlying index could fall over time."Leveraged" and "inverse" ETNs—which, like their ETF counterparts, attempt to amplify the performance of, or bet against, the underlying index—carry even greater market risk. Because of the way the math works on a leveraged ETN (as with a leveraged ETF), short-term volatility can kill you even if you're right about the long-term direction the market.
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."
Lipper's Roseen similarly warns about the dangers ETNs can pose to unsophisticated investor. "For an educated investor who realizes the pros and cons, you can get some very focused investments on a very short run that are very powerful and very useful," he says. "But they can be very detrimental as well as being useful. For the average investor, I'm a little hesitant to recommend these vehicles."