From the September 2014 issue of Research Magazine • Subscribe!

Beware: ETN Pitfalls Abound

After five consecutive yearly gains, the global equity market has more than recovered. Credit markets, with the exception of isolated places like Argentina, are healing. And the appetite for risk taking has returned.

The collapse of exotic financial products like credit default swaps (CDS), collateralized debt obligations (CDOs) and auction rate securities (ARS) is a distant memory. What about exchange-traded notes or ETNs? Now that financial markets have risen, are they any safer?

The Basics

ETNs, unlike their ETF cousins, are unsecured debt instruments that pay a return linked to the performance of an index, a currency or a single commodity. Similar to bonds, ETN payments rely on the full credit and faith of the entity backing the product. Many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years.

The value of ETNs is primarily determined by two factors: (1) the performance of their underlying index or asset, and (2) the creditworthiness of the issuer.

Pros and Cons

One of the biggest advantages of ETNs is how they’ve opened the alternative asset class universe, giving investors more opportunities to diversify and make tactical investment choices. ETNs offer exposure to a variety of markets such as commodities, single-country currencies and sovereign debt.

Other ETNs track narrow indexes with leverage and shorting strategies. Examples of this include the PowerShares DB Gold Double Short ETN (DZZ), the PowerShares DB Crude Oil Double Short ETN (DTO) and the PowerShares DB Agriculture Double Short ETN (AGA).

Another plus for ETN shareholders is zero tracking error. This is because an ETN issuer promises to give the shareholder a performance return that is identical to the underlying benchmark minus fees. As a result, ETNs don't suffer from index return to actual fund return discrepancies common to both mutual funds and ETFs.

The biggest shortcomings of ETNs are credit risk and taxation. It's important that advisors weigh these disadvantages against their advantages in order to make the right choice for clients.

Tax Issues

While ETNs are touted for their tax efficiency over mutual funds or ETFs, the truth is not all types of notes are taxed the same. For instance, commodity ETNs are taxed at the same capital gains rate as the commodity futures they use are when the futures are rolled. On the other hand, currency-linked ETNs are taxed as debt instruments.

Furthermore, the IRS has yet to give its opinion about the taxation of stock and bond ETNs. Currently, these types of ETNs have no annual tax because there is no interest or dividend distributions made. A capital gain (or loss) is realized when shareholders sell their notes or hold them to maturity.

“While there have been several opinions issued by law and accounting firms related to ETNs, we have not seen a definitive statement from the IRS regarding ETNs’ tax treatment,” states Andrew Clark, manager of alternative investment research at Lipper. “Most prospectuses acknowledge the uncertainty surrounding the tax treatment of ETNs.” How much damage would a negative tax ruling by the IRS be on the ETN market?

Credit Concerns

The value and safety of ETNs still relies very much on the credit market's perception of the issuer's creditworthiness along with credit ratings.

The 2008 credit crisis taught us about the perils of trusting hapless credit raters. Financial institutions like American International Group (AIG), Lehman Brothers and others that were blessed as economically sound were anything but. Their financial condition deteriorated so fast and unexpectedly, not even the hallowed credit rating agencies could keep up.

While major ETN sponsors like Barclays PLC (BCS), JPMorgan Chase (JPM) and Deutsche Bank AG (DB) appear to be financially strong today, the financial opinions of credit raters about them and other ETN issuers is an incomplete view of all the intricacies that impact large and complex companies.

The collapse of Lehman Brothers and its Opta ETNs is a real life example of worst case scenarios. After a few short months of being launched in 2008, the Opta ETNs never delivered on their promise. Lehman went bankrupt and noteholders got the same second class treatment as the rest of the defunct company's creditors. Interestingly, there was hope that another ETN issuer would scoop up Lehman's busted ETN promises to instill confidence in the ETN marketplace, but it never happened.

Allocation Dilemma

One of the complicating factors about ETN investing that should be at the forefront of consideration but is seldom discussed relates to how they are classified within a portfolio's asset allocation. Let's analyze a quick example.

One of the most popular ETNs is the iPath DJ-UBS Commodity Index ETN (DJP), which offers broad exposure to commodities like aluminum, gold and oil. DJP has $1.56 billion in assets and annual expenses of 0.75% that are right in line with its peers.

A financial advisor who wants a client to have 10% portfolio exposure to commodities may end up buying DJP. But is the client really getting market exposure to commodities? In reality, the client is getting market exposure to Barclays’ debt because DJP's ultimate performance and payoff relies on the company's ability to deliver on its promise to shareholders.

In this example, clients may think they’ve added commodities exposure when in reality, they’ve increased their portfolio's market exposure to fixed income—in this case, the bonds of a single company, Barclays.

Summary

Sound and 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 debacle illustrates, if the company backing the products goes out of business or encounters irreparable financial harm, ETN investors are left in the lurch.

While it might make sense to buy ETNs on behalf of a client, most of the major asset classes are already well covered by ETFs. The latter choice may have slightly higher tax consequences and tracking error, but are these disadvantages significant enough to overcome the credit and taxation risks of ETNs?

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