Revisiting ETNs

Exchange Traded Notes (ETNs) have been on the market since 2006, but many investors have shied away from them for various reasons.

Let’s revisit the idea of ETNs by taking a look at “ETNs Are Back, Warts And All:”

Exchange-traded notes are back, even as investors still worry about the risks that caused a stampede from these vehicles during the financial crisis.

ETNs, which resemble their more widely known cousin, exchange-traded funds, help investors bet on exotic investment themes like energy partnerships and interest-rate patterns. They have proved a recent hit, with assets topping $15 billion. That’s a big change from two and a half years ago, when ETNs held less than $4 billion and appeared to be shrinking fast.

Unlike ETFs or other mutual funds, ETNs require investors to take on the credit risk of issuing banks, something that still makes many investors uncomfortable even as they find themselves tempted by the vehicles’ convenience.

“These things have some warts on them,” says Oak Brook, Ill., financial adviser David Morgan. “But when they are the option with the least amount of warts, we go for it.”

In January, Morgan started buying JPMorgan Alerian MLP Index ETN (AMJ), which promises investors returns that match an index of master limited partnerships. These are energy investments that are tricky for small investors to buy directly because of their complex tax treatment. He’s invested about $10 million in the ETN, but says he limits the security to 2.5% of any single client’s portfolio to limit credit risk. J.P. Morgan Chase & Co. (JPM) declined to comment.

Exchange-traded notes were invented in 2006 by Barclays PLC (BCS, BARC.LN), whose iPath ETN family remains by far the largest. Barclays hoped the securities would capitalize on the iShares ETF brand, which it then owned, and fill in gaps in iShares’ line-up.

Like ETFs, ETNs typically promise investors the returns of an index and trade on an exchange at prices that closely match day-to-day values. But their unique legal structure gives them flexibility to target areas that are tricky for ETFs to reach. Unlike ETFs or conventional mutual funds, ETNs don’t actually own any assets. Instead, they essentially represent a side-bet between the holder and the issuing bank. If the bank were to fail, investors run at least a risk of not getting any money back, regardless of the performance of the index the ETN follows.

The issue was driven home during the financial crisis, when ETN issuer Lehman Brothers collapsed and other banks seemed to teeter on the brink. It’s not clear many investors actually were hurt. The Lehman ETNs, which were marketed for less than a year, had little in the way of assets beyond their seed capital.

ETNs do include an escape hatch for investors: Like ETFs, large market makers can buy up ETN shares and hand them back to the issuer at any time. The feature, designed to make sure shares trade in line with index values, should allow investors to cash out of funds at the first hint of trouble.

I have not used ETNs in my advisor practice, because of the inherent uncontrollable credit risk, as pointed about in the above highlighted paragraph. It is one thing to take on an unknown risk factor when you invest your own assets, but it is quite another when you deploy money for managed account clients.

I don’t see myself changing my view in this matter, but I would like to hear from you, if you have had any good, bad or indifferent experiences investing in ETNs. Feel free to post your comments below, and share your story with the rest of us.