Now That ETNs Have Come Back, How About a Refresher?

Exchange traded notes (ETNs) took a beating in the global credit crisis of 2008, not only in terms of performance alongside the broader market, but on a public relations front as major investment banks crumbled. Those days are fast becoming a distant memory.

In December 2008, ETN assets came in just under $5 billion. Today, that number has well more than doubled: at the end of 2010, assets in ETNs  soured to $14.3 billion - a gain of 225%.

Chalk it up to stabilization in the markets. A few years ago, it wasn't unheard of to wake up to news that a major bank had shut down or received a major bailout. Now that the dust has settled, let's bone up on ETNs.

Misunderstood Credit Risk

Oft-cited in stories about ETNs is that they’re debt issued by banks – if the bank goes under, you’ll have to take your place in line with the other creditors and wait for your payment. As big Wall Street Banks collapsed or were gobbled up by other banks in late 2008 and early 2009, investors became aware of this heightened risk and shunned the instruments.

It’s true that the collapse of an issuing bank is still a risk, but the market’s perceived risk of this occurring has declined significantly from where it was a year or two ago. While the overnight collapse of a big bank like Lehman Brothers and Bear Stearns is still a worst-case scenario, a more likely scenario for a troubled bank today is that it would go through a series of credit rating downgrades prior to bankruptcy. This is where ETNs offer some measure of protection.

ETNs possess a feature that allows investors to redeem them at net asset value on a daily or weekly basis. That means that if, for example, a bank that issues an ETN were to be downgraded, investors would have the right to redeem it at NAV, which is independent of credit quality, and thus not feel the pain of the downgrade.  

ETFs and ETNs are commonly seen as complementary products.

The downside of ETNs is the credit risk, which doesn’t appear in ETFs unless it holds an uncollateralized swap.  

But the benefit of ETNs is that they don’t have any tracking error – they deliver the direct return of the index minus a fee. In addition, there are a number of products that can be brought to market as an ETN, but not as an ETF because of any number of factors – ‘40 Act restrictions, inefficient taxation and so on.

The Future of the Industry

Now that the industry is back on track, don't be surprised to see more innovative launches. iPath has a slew in registration.

ETNs have a lower fixed cost than ETFs, therefore, ETNs don’t have to achieve the same level of assets under management in order to be economically viable for their sponsors. The general belief in the ETF industry is that a fund needs to hit at least $100 million in assets to be profitable. [ETN Is Another Way to Get Your Commodity Fix.]

Because ETNs have lower asset hurdles, issuers can be more aggressive in the products that they bring to market.