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ETNs have been in news of late, unfortunately for wrong reasons. Earlier this month, Credit Suisse delisted its two ultra-popular exchange-traded notes— VelocityShares 3x Long Crude Oil ETN (UWTIF - Free Report) and VelocityShares 3x Inverse Crude Oil ETN (DWTIF - Free Report) --that gave investors triple leveraged/and triple leveraged inverse exposure to a crude-oil index.

Usually funds liquidate when there is a lack of investor interest but that was not the case with these two ETNs which had almost $1.9 billion in assets. Unexpected liquidations can result in adverse tax consequences. After delisting, these securities trade over the counter where getting a fair price could be almost impossible for investors.

Since most investors confuse ETNs with ETFs, I think it would be appropriate to discuss the differences and risks associated with ETNs.

What are ETNs?

ETNs are unsecured debts issued by a major bank. They do not actually hold any securities; instead an issuing bank promises to pay to investors the amount reflected by the index’s performance (minus fees).

Are there any risks associated with ETNs?

Being debt instruments, usually unsecured debt by the issuing institution, ETNs face some level of credit risk. This means that if the issuing firm were to go bankrupt, investors may not receive their full investment back, if anything at all.

That actually happened with three ETNs sponsored by Lehman Brothers, when that firm filed for bankruptcy in 2008.

Furthermore, because ETNs are debt, they have a maturity date—usually about 30 years after the issuing date—when the note’s principal is then paid out to investors.  Some ETNs can also be called in by their issuer before the maturity date.

Usually ETNs trade at fair prices, i.e. close to their intrinsic values. But at times certain ETNs’ prices deviate from their NAVs and they can trade at a premium or discount to their NAVs. If you buy an ETN when it is trading at a premium, you can incur losses if you sell after the premium crashes.

The popular oil ETN iPath S&P GSCI Crude Oil Total Return Index ETN (OIL) was trading at almost 50% premium over its NAV for some time earlier this year. In fact, Barclays had issued a notification warning investors about ETN premiums.  As expected, the premium plunged after some time, making investors vulnerable to unexpected losses. 

These price disruptions occur when for some reason the ETN sponsor suspends creation mechanism. Currently there are 61 ETNs in the market (about a third of total ETN market) where new share creation has been suspended and these ETNs remain vulnerable to price disruptions.

At times, providers decide to liquidate notes for some reason like. If this happens, the liquidity for the ETN can dry up or just evaporate.

Are there any benefits associated with the ETF structure?

One of the most important benefits is the elimination of tracking error because an ETN doesn't actually hold securities in an index. Instead, an ETN promises to match the return of a particular benchmark index.

Then in certain asset classes particularly commodities and MLPs, ETNs are much more tax efficient than ETFs. In fact, MLP is the only asset class, where I recommend ETNs over ETFs due to their tax efficiency.

For more on the subject, please watch the short video below:



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