Risks, Upsides and Downsides of Exchange-Traded Notes

Risks

While the risk of credit-related losses among exchange-traded notes is real, there are additional safeguards in place to help minimize the possibility of investor losses. Some ETNs hold pledged collateral specifically to secure the claim. This increases the chance of a speedy and full payback in case the issuing bank defaults. Also, ETN holders are able to redeem shares at par with the issuer on a daily basis. Although retail investors won't normally be able to take direct advantage of this as the issuer often requires a large minimum number of shares to be redeemed, the usual arbitrage engaged in by market makers that prevents large premiums and discounts also applies here. This feature reduces the chance that investors will be caught holding an ETN that defaults.

Understanding the tax consequences of any investment should be at the forefront of the investment-selection process for all individual investors. Because ETNs are a type of debt instrument, they often have extremely lengthy prospectuses that detail the tax consequences as well as the unique creation and redemption process that ETNs employ. While exchange-traded funds are very tax-efficient vehicles, ETNs are often even better.

The upsides

So, why do some investors use ETNs over ETFs despite the additional credit risk? The ETN format can make it cheaper to invest in indexes that would be difficult and expensive to replicate through a fund, like leveraged, volatility, or specialty commodity indexes. The fact remains that ETNs are really the most effective (and often only) vehicles for investors seeking exposure to assets like foreign currencies or asset-allocation strategies (as specialty satellite holdings, of course).

The downsides

A downside to accessing less-liquid and more-exotic securities is that, occasionally, the bank promising the return of the index may encounter difficulty proving the stated return stream in a cost-effective manner. This could happen if the market for the underlying securities is performing abnormally or if regulators impose position limits on the target securities (both of these events have happened and impacted the trading of certain ETNs). In these instances, creations of new securities were suspended, and the existing ETN shares began trading at extremely high premiums. Investors seeking exposure to those notes were sorely disappointed after purchasing the ETN shares for premiums well above, sometimes 100%, the net asset value.

In the past, some investors have confused premiums and discounts with tracking error. Do not let yourself fall victim to this same mistake. Tracking errors are calculated using the net asset value (NAV) of a fund, which is often different from the price listed on a stock exchange. If the price of the ETN is greater than the NAV, the ETN is trading at a premium. On the other hand, if the price of the ETN is less than the NAV, the ETN is trading at a discount. Purchasing or selling an ETN at a significant premium or discount to NAV will lead to an investment performance that is materially different than that of the underlying index and the accumulated fees.

Another potential downside to ETNs is that they are not governed under the same regulatory structure as ETFs and open-end mutual funds. ETNs are not regulated under the Investment Company Act of 1940, meaning that common shareholder protections that investors have become familiar with do not apply. One example of such a difference is in the calculation of fees. While ETNs may list stated "expense ratios," they are oftentimes calculated in complicated and confusing manners. Reading the prospectus is crucial to understanding how much these funds will cost you.