ETNs Look Safe. Investors Could Get Bitten.

Exchange-traded notes are wolves in sheep’s clothing. While they sound like a close relative of exchange-traded funds, which have become popular for good reason, they are very different beasts. Most retail investors should steer well clear. ETNs in the U.S. have burned through nearly half of the $26 billion invested in them since 2006, according to rough estimates by Ben Johnson, director of global ETF research at data provider Morningstar. Issuers argue that such calculations are deceptive, as most ETNs are used tactically by sophisticated investors to make short-term hedges or bets. Either way, the asset class is expensive, risky and complex.

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Investors can be forgiven for associating ETNs with ETFs. The latter, which are bundles of securities that mostly track indexes, are worth nearly $10 trillion globally. They are a cheap way to make diversified investments in a range of asset classes, can be easily traded and typically have strong governance. In contrast, ETNs are like a zero-coupon bond that is listed on an exchange by the issuing bank. Rather than accruing interest, the note’s value changes according to a contractually defined formula. The products are typically designed to track some specific asset’s performance, such as a commodity, currency or index of volatility, equities or bonds. Like ETFs, they come in straight, inverse and leveraged varieties. Most trade on exchanges, though a few have been delisted.

ETNs do serve a purpose, providing exposure to difficult-to-buy asset classes such as coffee or volatility indexes. There isn’t the tracking risk associated with traditional index funds, which often end up with too much cash. And ETNs can offer tax advantages over the assets they track as gains on most ETNs are taxed only when they are sold.

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Some terms are standardized, but issuers retain significant flexibility in their design. Few investors read the fine print and the majority don’t understand the particulars of the underlying exposure, says Mr. Johnson, frequently resulting in painful losses. Some key items to watch are early-redemption clauses, the potential to delist from an exchange, which makes it tougher to sell, and when a bank can stop creating units, which risks opening up a valuation gap between the note and what it is tracking. Unlike ETFs, which must be run by a separate investor-focused board, ETNs can be managed by issuers as they please. Another source of risk is that ETN returns usually compound daily. This can magnify volatility or lead to significant gaps from the simple annual return of an asset, particularly for leveraged notes. The asset class also is relatively expensive, costing between 75 and 100 basis points annually, much more than most ETFs. Finally, noteholders are exposed to the credit risk of the issuing banks.

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The exotica of the investment world might seem exciting, but retail investors should keep a safe distance. ETNs have serious teeth.

https://www.wsj.com/articles/etns-look-safe-investors-could-get-bitten-11649410203 (subscription)