A recent article from the Wall Street Journal’s John Spence highlights the struggles facing exchange-traded notes, or ETNs, the smaller and less-known and cousins to the tremendously popular ETFs. Although similar to ETFs in many respects, ETNs have some key differences- mainly that they are debt instruments issued by banks, rather than a share in a portfolio of assets. As such, holders of ETNs face credit risk related to the financial health of the underlying issuers. Spence contends that the downfall of Lehman Brothers and Bear Stearns, both of whom issued ETNs, may have caused irreparable harm to these investment vehicles.
Total assets in ETNs peaked at $7.5 billion in July 2008, before falling to a low of $3.5 billion in late 2008 amidst the worsening credit crisis. Recently, total ETN assets were approximately $5.8 billion, or about 10% of the size of the ETF industry. Currently, there are ten ETN sponsors in the market, with Barclays and Deutsche Bank AG being the two largest.
So why are ETNs struggling so mightily while ETF assets continue to grow? The answer lies in a few critical differences between these securities. ETN investors may face significant losses in the event of a bankruptcy of the underlying issuer (which is often a bank). Although this possibility is generally remote, there is evidence that some advisers are opting for ETFs over ETNs to minimize credit risk. Although ETNs have some unique advantages over ETFs – mainly their simplified tax accounting and reduced tracking error – investors appear to be more comfortable investing in ETFs, at least in the current environment.
Many ETNs are designed for difficult-to-reach markets, including commodities and international markets. Only two new ETNs (VXZ and VXX) have been issued to date in 2009. Both of these ETNs track an index of futures based on the CBOR Volatility Index, or VIX.
Down But Not Out
While ETNs have had difficulty gaining traction with investors, I wouldn’t be surprised if they continue to gradually gain market share and work their way into the portfolios of more and more investors. The advantages of ETNs are real and the exposure they offer is in many cases unique. As the credit crisis (hopefully) begins to fade from memory, appetite for risk may return, and default risk for these securities may all but disappear. Then again, I’ve been fooled before.