For the most part, ETFs and ETNs are similar. Both offer
investors basket exposure to a particular asset class and they can
each trade on the open market throughout the day.
However, there is one distinction between the two that investors
should always be aware of; credit risk. ETFs have no credit risk
and the issuing institution is really of little to no importance to
an individual investor. The opposite can be said for ETNs, as these
securities are debt instruments of the underlying institution,
generally senior unsecured notes (read
ETF Investors: Beware the Coming ETN Backlash
).
This means that an ETN doesn't actually hold any securities, and
instead just offers to pay investors a return equal to an
underlying benchmark. While this eliminates tracking error, it does
expose investors to the credit risk of the issuing institution. If
this firm goes belly up, ETN investors may not be made whole, a
situation that cannot happen when dealing with Exchange-Traded
Funds.
Usually, this problem isn't really much of a concern and it
should be more-or-less put out of investors' minds for the most
part. Yet with that being said, investors should remember this ETN
issue when looking at any of the iPath ETNs thanks to Barclays'
ongoing LIBOR scandal.
This ongoing controversy stems from accusations that Barclays
has been engaged in a scheme to alter the London InterBank Offered
Rate, popularly known as LIBOR. While the details of the scandal
are still being flushed out, it now appears
that the government of Great Britain encouraged
Barclays -who often had a high LIBOR rate-to nudge its rate lower
in order to keep funding costs low and make it appear that the
banking system was healthier than it actually was.
It is also important to note that Barclays doesn't appear to be
the only one engaged in the scam and that many more banks could be
involved by the time the full details of the scandal are released.
Instead, Barclays could just either be the current focus of the
scandal or the tip of the iceberg on something much bigger (see
The Five Best ETFs over the Past Five Years
).
Already, Barclays has been forced to pay a fine of nearly half a
billion dollars while its CEO has resigned as well. Some analysts
are also forecasting that the firm may also be very risk averse
once its next CEO steps into the role, while a breakup of the bank
cannot be ruled out as a direct repercussion of the LIBRO fixing
scandal.
Thanks to these issues, many
credit rating organizations have rethought
their position on Barclays. While a major downgrade hasn't come
yet, many of the agencies have slashed their outlooks, suggesting
that a downgrade could be in the cards in the near future,
especially if more fines or turmoil hits the global bank.
While it is important to note that the bank is not in any
immediate danger, a further expansion of penalties or a breakup of
the bank into smaller units could have a negative impact on the
firm's credit rating, and force some investors to pause before
buying up any of the company's ETNs.
This is because, as we stated earlier, an ETN carries the credit
risk of the underlying institution, unlike their ETF counterparts.
So, if Barclays continues to face issues-and especially if they
look to become severe-some could start to waver on investing in
Barclays debt instruments, including the company's iPath ETNs.
In fact, currently Barclays is the issuer behind ETNs which
account for nearly $6.9 billion in AUM combined. This makes the
bank a major player in the ETN world and one of the most in focus
companies for its credit risks (read
ETFs vs. ETNs: What's The Difference?
).
While most of their notes are somewhat unpopular, there are a
few that have accumulated a decent amount of assets. Below, we
highlight a few of the company's most popular notes as well as some
ETF alternatives for investors to pick from instead.
Once again, Barclays will most likely be fine, but for those
looking to limit risks as much as possible, an ETF approach could
be the way to go until this storm blows over. Until then, a good
proxy for worries on the issue could be a look to the
premium/discount on iPath's ETNs.
If a big discount appears, suggesting that the product is
trading less than its NAV, it could imply that worries are
beginning to creep up on Barclays and its credit worthiness. As of
right now, this isn't a problem, but investors should look for this
'canary in the coalmine' in regards to the following three Barclays
ETNs as the scandal continues to unfold:
iPath Dow Jones UBS Commodity ETN (
DJP
)
This product is easily the most popular in the iPath lineup
having amassed over $2 billion in AUM. The product targets the
broad commodity market and is currently trading at a slight
discount to NAV. However, it is still within an acceptable range,
so investors shouldn't be concerned at this point in time (read
USAG In Focus As Agricultural Commodity ETFs
Soar
).
As a liquid ETF alternative, investors could look to the
PowerShares DB Commodity Index Tracking Fund (
DBC
)
. This product has close to $5.7 billion in assets and does not
have any of the same credit issues that DJP is suffering from,
making it a potential replacement. However, investors should
remember that these products in the commodity space are structured
as partnerships so a K-1 may be necessary instead at tax time.
iPath S&P 500 VIX Short-Term Futures ETN (
VXX
)
For a play on broad market volatility, VXX is currently the most
popular choice in the market today. The product usually does volume
of about 42 million shares and has AUM of about $1.7 billion (see
Inside The Barclays S&P VEQTOR ETN
).
While the ETF alternative segment is thin in the volatility
world, investors still have the
ProShares VIX Short-Term Futures ETF (
VIXY
)
. This product has a decent volume and asset base, although it is
nowhere near what investors see in VXX. Yet, it does get rid of the
credit risk issues since it does have an ETF structure.
iPath S&P GSCI Crude Oil TR Index ETN (
OIL
)
This product from iPath is actually trading at a slight premium
to NAV at last look, suggesting that worries aren't very high for
this note (at least for now). Much like the other two on the list,
this one is very popular, trading more than 770,000 shares a day
while possessing more than $430 million in AUM (read
Three ETFs for the Unconventional Oil
Revolution
).
In terms of ETF alternatives, there are a few in the oil space.
Easily the most popular is the
United States Oil Fund (
USO
)
. This product has more than $1.2 billion in AUM and does
exceptional volume that is approaching 8.5 million shares in a day.
Much like in the case of DBC, USO is structured as a partnership,
meaning that a K-1 will be necessary come tax time although credit
risk is zero in the fund.
Want the latest recommendations from Zacks Investment Research?
Today, you can download
7 Best Stocks for the Next 30 Days
.
Click to get this free report >>
Follow
@Eric
Dutram
on Twitter
PWRSH-DB COMDTY (DBC): ETF Research Reports
IPATH-DG AIG CM (DJP): ETF Research Reports
IPATH-GS CRUDE (OIL): ETF Research Reports
US-OIL FUND LP (USO): ETF Research Reports
PRO-VIX ST FUT (VIXY): ETF Research Reports
IPATH-SP5 VX ST (VXX): ETF Research Reports
To read this article on Zacks.com click here.
Zacks Investment
Research
Want the latest recommendations from Zacks
Investment Research? Today, you can download 7 Best Stocks for the
Next 30 Days. Click to get this free report