2 ETNs' manic swings point out peril of use

Apr 8, 2012 @ 12:01 am

By Jason Kephart

Two recent instances in which exchange-traded notes veered wildly from the indexes they are supposed to follow serve as a harsh reminder to financial advisers that ETNs are complex, don't always work as intended and require extra vigilance.

ETNs are unsecured-debt instruments that track an index. They typically get thrown into discussions alongside exchange-traded funds, but other than the ability to trade intraday on an exchange, the two products are, in fact, vastly different.

Unlike ETFs, which hold either stocks or bonds as their underlying investments, ETNs don't hold anything: They are contracts between an investor and an investment bank stating that the bank will deliver the return of an index minus fees.

In recent weeks, ETNs issued by Credit Suisse Group AG and Barclays PLC have made headlines, and drawn scrutiny from regulators and brokers-dealers, because their shares began to trade at extreme premiums to their respective indexes. After the banks stopped issuing new shares of the notes, demand for the shares drove prices to around twice the actual net asset value of the notes.

When Credit Suisse announced it would start issuing new shares of its ETN late last month, the premium at which the existing shares were trading was wiped away; share value plummeted 50% in two days.

That got the attention of the Financial Industry Regulatory Authority Inc., the Securities and Exchange Commission and Massachusetts' securities regulator, all of which are looking into how the ETNs are sold to investors.

Charles Schwab & Co. Inc., meanwhile, is considering whether to require that investors be given an extra set of warnings when they are getting set to trade an ETN.

The extra attention being drawn to ETNs is warranted because, as these two cases demonstrate, some investors don't understand how the notes work, said Mariana Bush, an analyst of exchange-traded products at Wells Fargo Advisors.

“When exchange-traded products begin trading at a very, very high premium, it leads me to believe there is a fair amount that investors don't understand,” Ms. Bush said. “If people knew what they were doing, they would be looking at where the [net asset value] is.”


The heightened scrutiny comes as the popularity of ETNs continues to surge. The products now hold $17.4 billion in assets, up from under $5 billion five years ago, according to Morningstar Inc.

Dominick Paoloni, chief investment officer at Investment Portfolio Solutions, likes ETNs because of the promise of getting the index's returns without a tracking error — a flaw inherent in all ETFs, at least to some degree.

“I want to know that I'm going to move with the actual index,” he said.

But as the Credit Suisse and Barclays cases have proven, just because a bank promises it will track an index, it doesn't mean that the shares of the note actually will.

Barclays' iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN (GAZ), for example, saw the premium of its share price go as high as 134%, and as of April 3, it was trading at a 97% premium — meaning investors were paying nearly $2 for $1 of the ETN's exposure.

Barclays stopped issuing new shares of the erratic ETN in 2009 because of position limits on the futures contracts it uses to hedge against the note, but the shares didn't start behaving in an unusual manner until demand for natural gas exposure skyrocketed this year.

If Barclays were to begin issuing new shares, it's likely that the shares would drop to the index's levels. Through April 3, the ETN's shares had gained 0.13%, while the index itself had lost 37%, according to the iPath website.

Kristin Friel, a spokeswoman for Barclays, declined to comment.

It shows that investors need to do extra homework because the product may not be what they think it is, said Scott Freeze, president of Street One Financial LLC.

“When an asset class gets really hot, or starts to pop, that's when you're most likely to see ETNs start acting differently,” he said.

In addition to keeping an eye on an ETN's NAV, advisers also have to pay special attention to the way fees are calculated.

About half of the top 20 ETNs by assets use a “path-dependent” fee structure, which uses the weighted-average NAV measured over a period of time, such as a month, a year or even from inception, rather than using the daily NAV, as ETFs and mutual funds do.

It causes the notes to charge more when the NAV is falling, said Samuel Lee, an analyst at Morningstar Inc.

“It's kind of ridiculous that some of these products are actually out there, with the things they have hidden in the fine print,” he said.



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