SAN DIEGO (ETFguide.com) - Global stock markets have risen from
the ashes. Credit markets are in the midst of a recovery. And the
appetite for risk taking has returned.
The implosion of exotic financial products like credit default
swaps (CDS), collateralized debt obligations (CDOs), and auction
rate securities (ARS) seems like light years ago. Given a few more
quarters of steady growth, I'm sure a certain segment of the
population will start doubting these diseased products ever
But what about exchange-traded notes or ETNs? Now that the
market has risen, are they any safer?
ETNs are unsecured debt instruments that pay a return linked to the
performance of an index, a currency or a commodity. In a similar
arrangement to investing in bonds, ETN payments rely on the full
credit and faith of the institution backing the product. Many ETNs
have a long-term maturity date that can be anywhere from 20 to 30
The iPath Dow Jones-AIG Commodity Index Total Return ETN
(NYSEArca: DJP), the iPath S&P GSCI Total Return Index ETN
(NYSEArca: GSP), and the iPath S&P GSCI Crude Oil Total Return
Index ETN (NYSEArca: OIL) are among the most popular notes.
Other ETNs track narrow indexes with leverage and shorting
Examples of this include, the PowerShares DB Gold Double Short
ETN (NYSEArca: DZZ), the PowerShares DB Crude Oil Double Short ETN
(NYSEArca: DTO), and the PowerShares DB Agriculture Double Short
ETN (NYSEArca: AGA).
At the end of October, there were 84 U.S. listed ETNs with
around $7.6 billion in assets according to the National Stock
Exchange. Among the top ETN providers are Baclays' iPath notes
($5.2 billion), Deutsche Bank ETNs ($829 million) and Swedish
Export Credit ($771 million).
The Sales Pitch
The typical ETN sales pitch will go something like this: 'In order
to be more diversified, Mr. & Mrs. Jones, your portfolio will
require exposure to hard to reach asset classes like commodities,
currencies, or other unique opportunities.'
In other instances, the sales pitch will focus on how certain
ETNs are tax-efficient instruments. The pitch might even include
mentioning how ETNs benefit from zero tracking error, which
basically means you get identical performance to the underlying
index or security, minus your fees. But before you bite, know the
full spectrum of risks.
Under the current tax law, commodity and equity linked ETNs are
taxed as prepaid contracts. This means investors incur tax
consequences only upon the sale, redemption, or maturity of their
note. However, this tax loophole is likely to disappear in the
In late 2007, the Internal Revenue Service issued an adverse tax
ruling on currency linked ETNs. The rule stated that any financial
instrument linked to a single currency regardless of whether the
instrument is privately offered, publicly offered or traded on an
exchange should be treated like debt for federal tax purposes. ETNs
linked to commodity and stock baskets aren't likely escape IRS
rules for much longer. This looming tax risk is almost never
mentioned in the ETN sales pitch.
For investors relying on the safety of credit ratings to help them
locate a safe ETN issuer, think again.
The 2008 credit crisis taught us about the danger of trusting
hapless credit raters. Financial institutions like American
International Group (
), Lehman Brothers and others that were blessed as 'sound' were
anything but. Their financial situation deteriorated so fast and
unexpectedly, not even the hallowed credit rating agencies could
While major ETN sponsors like Barclays PLC (
) and Deutsche Bank AG (
) appear to be financially sound, gold-glittered credit ratings are
far from a guarantee things will remain the same.
After a few short months of being launched in 2008, Lehman's
Opta ETNs never delivered on their promise. Lehman collapsed and
note holders got the same second class treatment as the rest of the
defunct company's creditors.
ETNs also carry market risk, which comes with any investment
product. The underlying securities may not perform in a manner that
produces a capital gain for the investor.
Let's review what you've just learned: ETNs carry credit risk,
taxation risk and market risk. Why that's three strikes! Just make
sure, you're not the one striking out.
Buyers of ETNs should not let a rise in global stocks trick them
into a false sense of security.
Purposeful investing should be quick to reduce financial risks,
not increase them. Along with market risk, ETN investors also bear
credit and taxation risk. As the Lehman ETN blowup illustrates, if
the company backing the products goes out of business, ETN
investors are left in the lurch.
All of the asset categories that investors need to build a fully
diversified portfolio are already being well covered by index ETFs.
You don't need exposure to the Japanese Yen or some other
specialized investment strategy to be diversified. And you
certainly don't need the additional risk of exotic financial