Conference panel addresses the credit risk and tax worries surrounding ETNs.
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By John Gabriel | 01-14-09 | 08:30 AM | Email Article

The Inside ETFs Conference's Tuesday afternoon panel titled "All about Exchange-Traded Notes (ETNs)" was an informative discussion detailing some of the misconceptions about these often-misinterpreted products from some of the industry's top players. No doubt, with the collapse of several financial institutions (namely Bear Stearns and Lehman Brothers) amid the credit crisis of 2008, investors' apprehension to take on credit risk has escalated--and justifiably so. With credit risk on the top of most investors' minds nowadays, some have questioned the viability of the ETN structure altogether.

John Gabriel is a strategist for Morningstar’s manager research team.

The panel, which was moderated by Paul Amery, European editor of index publications, included Philippe El-Asmar, managing director, head of solutions sales, Americas of Barclays Capital, Lloyd Raines, first vice president of RBC Capital Markets, and Kevin Rich, managing director, Deutsche Bank AG, CEO, DB Commodity Services. A critical distinction that we think is important to make concerning this panel is that Raines from RBC is a practicing financial advisor, while the other two panelists were representatives of exchange-traded product providers.

The session kicked off with a brief background on the ETN structure, as moderator Paul Amery asked Philippe El-Asmar to explain exactly what an exchange-traded note is. El-Asmar started by stating that ETNs are essentially unsecured promissory obligations issued with the backing of a financial institution. These "notes," which can be thought of as bond issuances, guarantee investors the return on a given index and have stated maturity dates (though they can be bought and sold throughout the day like stocks in the interim for those who don't plan to hold to maturity). Thus, ETNs carry the credit risk associated with the backing financial institution but will not produce any tracking error. Therefore, in El-Asmar's opinion investors could view the ETN structure as somewhat of a trade-off between credit risk and tracking error.

Raines then stepped in to point out the significant difference in magnitude of that trade-off that El-Asmar refers to. From a financial advisor's perspective, a negligible tracking error is a nonevent. (Even a tracking error of a few percentage points--which is rare--would still be manageable.) On the other hand, it is a much more serious event if a backing financial institution goes bust (a la Lehman Brothers), leaving a financial advisor to explain to their client(s) that their entire investment has completely evaporated.

Morningstar's Take: El-Asmar's brief overview was helpful for the uninitiated. Although many of the events of 2008 have been referred to as "once in a century events," we still think that investors should approach these products with a certain degree of caution--always taking the initiative to explore the alternatives. In this debate, we'd lean toward agreeing with Raines--while the trade-off is important to evaluate, investors shouldn't lose sight of the ultimate consequences and differing magnitudes related to the trade-off. In our opinion, we'd much rather sacrifice a few basis points in tracking error than to have our investment completely implode--only one outcome allows the investor to live to fight another day. This, however, shouldn't be interpreted as a warning to avoid all ETNs--it's simply a "heads-up" to offer some perspective. After all, ETNs still offer investors access to specialized asset classes that often do not have a comparable alternative available in the ETF format.

Despite the lack of tracking error that ETNs enjoy, we think that it is also a good practice to monitor whether the market price of a given ETN trades at a discount to its indicative NAV. This would be a "red flag" indication of the market's nervousness related to the issuer's creditworthiness. Raines reminded us, however (and we tend to agree), that markets don't always act perfectly in the neoclassical sense. (Behavioral economics also play a role in the markets--at least in the near term.) Rich of Deutche Bank then pointed out that the Lehman ETNs had actually tracked their NAVs accurately ahead of their eventual collapse. In our view, this is an interesting point as it relates to market efficiency (or inefficiency), considering the difficulty to accurately discount (or price) a binary event--the bank survives or it doesn't. In the end, to fully grasp the extent of the credit risk associated with a given ETN, investors should lean on a stronger fundamental analysis of the bank, rather than potential discounts in the market price versus the NAV.

On a separate note, we'd like to point out that the amount of assets invested in the family of ETNs backed by Lehman Brothers was approximately $15 million; the majority of which we suspect was seed capital. Investors unfortunate enough to have held any of the Lehman ETNs to the end will unfortunately have to stand in line with the rest of the creditors and debt holders--a process that could take more than a year. Adding insult to injury, they'd be standing in line as unsecured creditors with a chance to recover pennies on the dollar--if that.

The Discussion then took a step back to note that these products, while relatively new to many, have actually been around for quite a while, with Barclays issuing the  iPath Dow Jones-AIG Commodity Index  back in 1996. Today there are 12 providers of ETNs, and the number of new issues continues to grow at a rapid clip (yes, even in 2008 amid the malaise in the financial sector). One of the main reasons that ETNs have appealed to and been embraced by the exchange-traded-products community is because their unique structure allows the providers to replicate asset-allocation strategies and gain access to asset classes like commodities, foreign markets, and currencies. In essence, thanks to the ETN structure, individual investors can gain access to these specialized asset classes that were once the exclusive domain for institutional investors and the ultrarich.

ETNs can offer investors exposure to these more "exotic" or alternative asset classes because of their regulatory structure. Whereas ETFs are subject to the Investment Company Act of 1940, ETNs fall under the Securities Act of 1933. We'll save the technical details for a future discussion (but we've provided links for those interested in digging into some of the nuances of these regulatory acts). The major point here for investors trying to differentiate between ETFs and ETNs is that, with an ETF, the investor has a claim on the basket of securities held by the fund. ETN investors are promised the return of a given index but do not have any claims on the assets that constitute the index, hence, the importance of the creditworthiness of the backing bank.

Morningstar's Take: In terms of portfolio optimization theory, ETNs have ultimately expanded investors' opportunity set (it was previously impossible or impractical for individuals to gain pure commodity or currency exposure), which should help advisors in constructing minimum variance portfolios. Still, we understand investors' apprehension concerning the credit risk associated with these products. Yet, despite the associated risks, we still believe that ETNs are a useful tool and a viable investment choice for investors. Obviously, investors must still consider their goals and understand their risk tolerance before diving in headfirst.

Moderator Amery went on to probe the panelists on the uses of ETNs. El-Asmar stepped in to state that ETNs should be viewed as complementary to ETFs. ETFs and ETNs don't necessarily compete head-to-head, as the strategies offered by the different structures vary greatly because of the aforementioned differences in their regulatory structures. Also, investors should look at their own objectives and risk tolerances to make the decision between the trade-off of credit risk versus tracking error.

Morningstar's Take: Again, we agree with El-Asmar's stance on ETNs. The fact remains that ETNs are really the most effective (and only) vehicles for investors seeking exposure to assets like foreign currencies or asset-allocation strategies (as specialty satellite holdings, of course). However, for risk averse investors (and financial advisors) who are unwilling to assume the credit risk and potential loss of their (or their clients') investment--regardless of how low the probability of default may be--we think avoiding the structure altogether could be a prudent and sensible choice.

Wrapping up the panel's discussion was a brief overview of the taxation of ETNs. The most important takeaway on this topic is that ETNs only incur a taxable event when an investor sells his or her shares. If held for longer than a year, any gains would be taxed as long-term capital gains and shares held for less than a year would be treated as ordinary income. The panel also made clear that most "traditional" ETNs (for example, asset-allocation strategies and currency notes) do not pay dividends or make distributions. However, it gets a little hairier when dealing with the single-currency ETNs. Most single-currency ETNs will pay a monthly distribution on interest earned, and that distribution is taxed as ordinary income. Also, what many individual investors may have overlooked is that when currency ETN shares are sold, they are taxed as ordinary income (again, this ties back to the fact that these are debt instruments).

El-Asmar also made sure to point out that not all ETNs are created equal. In all, there are 12 firms that provide ETNs; investors would do themselves a great service by not only understanding the products themselves but also gauging the financial health of the financial institution that backs a given ETN. Raines took issue with the fact that El-Asmar simply advises investors to read and understand the prospectus. Raines even went so far as to hold up an example of an ETN prospectus (highlighting the "thickness" of the regulatory filing) to give the conference attendees an idea of just how lengthy and complex these vehicles (and their associated literature) can be. Raines' claim is that it seems like somewhat of a counterintuitive exercise, considering that one of the main advantages that exchange-traded-products offer is their simplicity and extreme transparency.

Morningstar's Take: Understanding the tax consequences of any investment should be at the forefront of the investment-selection process for all individual investors. Because ETNs are a type of debt instrument, they often have extremely lengthy prospectuses that detail the tax consequences as well as the unique creation and redemption process that ETNs employ. We understand Raines' concern that this can be overwhelming for the average investor, but thankfully subscribers can rely on us (the ETF research team) to decipher these complicated and lengthy documents in order to communicate the important takeaways of each ETN issuance in a clear and concise manner. (Stay tuned for more on this, and, as always, we welcome any and all subscriber questions and comments.)

Finally, as the moderator opened up the panel to questions from the audience, the issue of credit risk, not surprisingly, dominated the inquiries from the attendees. One of the most interesting points of this portion of the session was when Raines pointed out that Lehman Brothers was actually an A+ rated firm right up until its demise. With the credibility of the credit rating agencies being seriously called into question, considering the substantial wealth destruction that occurred on their watch in 2008, we obviously don't think that relying on those ratings is sufficient in assessing the credit risk of a given ETN. However, El-Asmar aptly pointed out that if one had followed the implied spreads on the Credit Default Swaps (CDS) for Lehman Brothers, then the "red flags" would have been very apparent.

Morningstar's Take: In our view, it will probably be some time before investors are comfortable with taking on additional credit risks. Unfortunately, most individual investors don't have a Bloomberg Terminal in their homes to monitor CDS spreads. But, fortunately, the Morningstar ETF research team does have access. Stay tuned for updates on our ETN coverage. We plan on monitoring the CDS spreads and leveraging our fundamental equity research for the 12 banks that issue ETNs in order to assess the risk of default for ETN holders. As 2008 has illuminated, capital preservation and understanding credit risk are two central tenants of successful investing. We'll do our best to bring forth the most relevant information and data on this topic to ensure that our subscribers are prepared and well-armed as we move through 2009 and beyond.


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