I recently returned from Singapore, where I participated in the Asia Indexing Conference. My Day 1 role was presenting to my Asian peers the difference between an Exchange Traded Fund (ETF) and an Exchange Traded Note (ETN).
We hear a lot today about ETFs. ETFs are certainly great products that reduce company risk and allow for superior diversification. I want to discuss the ETF’s Cousin, Exchange Traded Notes. Both ETFs and ETNs track an assigned index, trade like a stock and are very liquid. The similarities stop there.
ETFs are structured such that the shareholder owns a basket of securities. Should the ETF provider go bankrupt or shutdown the ETF, the shareholder will usually recieve cash for the market value of the basket of securities. If you own more than 50,000 shares, then you could request to take distribution of the securities.
ETNs are debt instruments. Debt instruments do not own anything but a promise to track an index. The largest ETN based on assets is Barclay’s iPath Dow Jones Commodity Index (DJP). From iPath’s website, we see DJP’s largest holdings are 30% energy, 21% grains, 19% industrial metals, 12% precious metals, 2% livestock and 16% other. At first glance, it would appear that you own commodities with this allocation. However, this allocation is used only as a measure for performance. An investor does not own any commodities, only a promise from Barclays to pay an investor the theoretical allocation of the commodity index. If an ETN provider should go bankrupt, the investor will not receive his or her investment back. Why? Because an ETN is considered an unsecured debt instrument.
An example of this is the recent Lehman Brothers failed ETNs. The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment. Shortly after Lehman’s collapse, Bear Stearn’s ETN holders were hours from the same fate, when JP Morgan stepped in an purchased the company.
Currently the top three ETNs based on assets are:
1. Barclays iPath Dow Jones AIG Commodity Index (DJP)
2. Powershares DB Crude Oil Double Long (DXO)
3. Barclays iPath S&P GSCI Crude Oil (OIL)
When purchasing an ETN, it is a good idea to ask yourself if you would lend money to the ETN provider. After all, ETNs are only a promise to pay, which is unsecured. One simple way to observe the risk of investing in an ETN is to look at the provider’s credit rating. On December 19th, 2008, CNBC showed Morgan Stanley, Goldman Sachs and HSBC with an A S&P rating. Barclay’s has a AA rating.
The credit rating is only a birds eye view (if that). For example, Barclay’s may have a AA rating, but recently the bank was speculated to become state owned because of its poor condition. We have seen the results of an ETN bankruptcy, but not a government takeover. My guess would be that the ETN would continue operating, but this market has been full of surprises.
So, now that you are scared of ETNs, why would you invest in an ETN? Access to certain markets or indexes can be difficult to manage from direct investing. An example of this would be an advisor who decided to invest directly into commodities. If he made a misstep, his client could end up taking delivery of the actual barrels of oil or herds of cattle. This would certainly not be adding value to the relationship, especially of the client lived in the city!
The structure of an ETN gives it great flexibility. This flexibility gives ETNs the ability to track the performance of commodities, countries with limited access, gold, volatility indexes, buy write strategies and currency. The cost of actually implementing these strategies through an ETF structure could be very expensive and have a wide tracking error. The ETN format allows perfect index tracking as long as the provider keeps their promise.
Always know what you are investing in..
Casey Smith – president/owner Wiser Wealth Management, Inc
Mr. Smith,
I just purchased JPMorgan Alerian MLP ETN for my IRA. Starting to wonder if I made a wise choice. I thought it was an ETF however, after making the purchase, I found out, it is a ETN. Would You consider this ETN to be a safe investment and, can a person buy and sell ETN’s like ETF’s? Any assistance would be greatly appreciated. Thanking You in Advance, Ed.
Ed,
ETNs do trade like ETFs which makes your investment very liquid. Your risk in the investment is the credit of JP Morgan as you do not actually own anything but a promise from them to track the performance of the Master Limited Partnerships (MLP) energy sector. Master Limited Partnerships do not fit well in an ETF because you would need to receive a K1 each year for gains or losses, possibly affecting your personal tax return. Because an ETN is a note rather than an investment directly into the partnerships, you get the returns (good or bad) and pass on any tax consequences (you may get a 1099). Being that it is in an IRA for you, maybe that is not a big deal. Is it safe? Look at it this way: JP Morgan now owes you money and your rate of interest is based on the returns of the Energy MLP index. IF JPM goes out of business, you will get 0 back. So, for the security of your investment you have to look at the credit quality of JPM.
I did a quick search for Energy MLPs and did not find an ETF. There was an article at Seeking Alpha by a writer that described your ETN as an ETF. Blind leading the blind there!! If you want an energy ETF check out ishares.com and look over their energy ETFs. Vanguard has a diversified energy ETF as well. These two companies are the BIG players in ETFs thus can bring the volume and assets under management to give you a better trade.
Hope this helped.
From the JPM site:
Benefits of investing in the JPMorgan Alerian MLP Index ETN
Exposure to a portfolio of energy MLPs through a single investment.
Quarterly coupons based on the cash distributions, if any, paid on the MLPs in the Index, less fees.
No K-1 forms will be received by investors as a result of their investment in the ETNs. The coupons are reported as ordinary income on Form 1099.
The ETNs trade on the NYSE, Arca.
Main risks in the ETNs
The ETNs may result in a loss.
The ETNs are exposed to the credit risk of JPMorgan Chase & Co.
The ETNs may not have an active trading market and may not continue to be listed over their term.
The payment at maturity or upon early repurchase of the ETNs will be based on the VWAP Level of the Index and not on the closing level of the Index. The VWAP Level of the Index will most likely differ from the closing level of the Index or the IIV.
The coupon payments on the ETNs will be variable and may be zero. The Accrued Tracking Fee reduces the potential coupons and/or the payment at maturity or upon early repurchase.
The Issuer’s obligation to repurchase the ETNs is on a weekly basis, and is subject to substantial minimum size restrictions.
You will not know how much you will receive upon early repurchase at the time that you elect we repurchase your ETNs.
What is the source on the top 3 ETNs based on assets? Searching around for such a list. Thanks!
At the time of the article the top ETN’s were from Morningstar’s US ETN database. The Top 6 as of May 2011 is as follows:
DJP iPath DJ-UBS Commodity Index TR ETN 3.2B
AMJ JPMorgan Alerian MLP Index ETN 2.6B
VXX iPath S&P 500 VIX Short-Term Futures ETN 1.4B
RJI ELEMENTS Rogers Intl Commodity ETN 919M
VXZ iPath S&P 500 VIX Mid-Term Futures ETN 788M
INP iPath MSCI India Index ETN 719M