If you look at the best-performing ETFs of 2019, the one sitting at the top of the leaderboard may surprise you. The Market Vectors-Indian Rupee/USD ETN is up about 125% year-to-date, and most of these gains came in the past month.
The ETN, which has less than $2 million in assets, seeks to track the value of the Indian rupee relative to the US dollar. And Indian rupee is actually down versus the US dollar year-to-date, as well as in the past month. The reason for INR's surge is that it is structured as an exchange traded note (ETN), which is currently trading almost 110% above its net asset value.
On the other hand, popular India ETFs like the iShares MSCI India ETF (INDA - Free Report) and the WisdomTree India Earnings Fund (EPI - Free Report) are almost flat or slightly down year-to-date, as the country faces an economic downturn.
Investors should understand that ETNs are not ETFs, and they come with some risks.
What are ETNs?
ETNs are unsecured debts issued by a bank. Unlike ETFs, they do not actually hold any securities; instead the issuing bank promises to pay to investors the amount reflected by the index’s performance (minus fees).
Being unsecured debt, ETNs face some level of credit risk. That means if the issuing firm goes bankrupt, investors may lose a part of or all their money. That actually happened with three ETNs sponsored by Lehman Brothers, when the firm filed for bankruptcy in 2008.
There are 161 US listed ETNs in the market with about $20 billion in assets currently. The credit risk of these ETN is actually quite low, but there are other issues associated with the structure.
Since ETNs are debt instruments, they have a maturity date, when the note’s principal is 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 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.
These price disruptions occur when for some reason the ETN sponsor suspends or closes creation mechanism. And that’s why happened in the case of INR.
“Due to market supply and demand, the price of the ETNs may trade at a premium above their closing or intraday indicative note value. Any such premium may subsequently decrease at any time and for any reason, resulting in financial loss to sellers who paid this premium,” per VanEck.
We have seen such instances earlier too. A popular oil ETN--iPath S&P GSCI Crude Oil Total Return Index ETN (OIL)--was trading at almost 50% premium over its NAV in 2016. In fact, Barclays had issued an investor alert urging investors to “exercise extreme caution” while buying ETN at a premium as they may experence "a significant loss if they sell the ETN at a time when such premium is no longer present.”
Are there any advantages of the ETN structure?
One of the most important benefits is the elimination of tracking error because an ETN doesn't actually hold securities. Instead, an ETN promises to match the return of a particular benchmark index.
Further, in certain asset classes, particularly commodities and MLPs, ETNs are much more tax efficient than ETFs.
Before you buy an ETF or ETN, it is important to do your homework and understand what you are buying. And also understand the risks associated with ETNs, if you decide to invest in them.
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