Should You Own ETNs?

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Firmly established in Wall Street's storied history are financial products which are sold as 'safe' that turn out to have the same risk as a slot machine gamble.

We've seen this sinister phenomenon with collateralized debt obligations (CDOs) that were supposedly backed by the collateral of 'rock solid assets' behind them. We've also witnessed the same sales pitch with auction rate securities ( ARS ), which offered a better yield than money market funds, but with the same level of risk, allegedly. In both cases, the money invested in CDOs and ARS got zapped.

Let's analyze the $16 billion market in U.S. listed exchange-traded notes (ETNs) to see the similarities.

ETNs vs. ETFs

While ETNs and exchange-traded funds (ETFs) are sometimes grouped together, or worse, confused as the same thing, they are not.

Unlike traditional ETFs , exchange-traded notes are debt obligations backed by the financial or banking institution that issues them. ETNs pay a return linked to the performance of a single security or index. Who pays the return? The financial issuer backing the note.

ETNs can track a variety of assets from commodities (NYSEArca: DJP), to the VIX Index (NYSEArca: VXX) and Indian stocks (NYSEArca: INP). ETNs are also used as day trading instruments for those that want leveraged long exposure (NYSEArca: DGP) or leveraged short (NYSEArca: DZZ) to gold or other assets.

Investors that choose to keep their ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. The annual fees deducted reduce the value of the payment. Maturity periods can vary and may be as long as 30 years. ETN investors that don't want to hold their note to maturity and sell it prior to maturity on the exchange where they trade.

European Banking Connection

Beyond the U.S.stock market's (NYSEArca: VTI) daily moves, Europe's financial crisis has subtle domestic implications.

The U.S. ETN marketplace is heavily composed of products issued by European banks. Furthermore, it would be safe to say that European banks themselves don't know how safe European banks are. Isn't that why they've been hoarding cash and isn't that why they've been parking other vast amounts with the European Central Bank?

Here's what ETFguide told its newsletter subscribers:

'From the very beginning of Europe's crisis, its leading voices (from Europe's Central Bank to its heads of state) have been consistent in one regard: They've continually underestimated the severity of the crisis each step of the way. They were wrong about Greece, Ireland and Portugal not needing bailouts - and they were badly wrong on the actual size of the bailout required. Is there any reason to believe they'll be wrong (again) about the alleged soundness of Europe's banking system?'

Which of Europe's banks are illiquid, overleveraged or on the verge of bankruptcy? Is it Britain's Barclays ( BCS )? Is it Germany's Deutsche Bank ( DB )? Is it Switzerland's UBS ( UBS )? Or is it someone else?

Soon enough, we'll know which of Europe's financial institutions will go belly-up. When full-blown interbank lending between European banks stops, (and we're almost there) the undercapitalized weaklings will come to the surface like cockroaches exposed to the sunlight.

Is History Repeating Itself?

Which ETNs are at the greatest risk of loss because of Europe's financial crisis? The September ETF Profit Strategy Newsletter outlined who the top ETN providers are, which ones to avoid and a protection strategy for navigating the storm.

During the 2008-09 Financial Crisis, the ETNs issued by Lehman Brothers got clobbered and eventually became worthless. Today, the $16 billion market for ETNs in the U.S. is much larger than it was three years ago, which means one thing: This time around, the same ETN blowup that's on the verge of occurring will much larger in scale and much uglier .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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