How ETNs Became ETFs’ Riskier, Less-Loved Cousins

Exchange-traded funds, which soared in popularity during the last decade, have a lesser-known cousin called the exchange-traded note. While ETFs and ETNs may sound a lot alike, there are huge differences, especially when it comes to risk. Massive price swings in 2020 have contributed to greater awareness about the downsides of ETNs. Now, their issuers are shutting them down at the fastest pace ever.

1. Remind me about ETFs -- how do they work?

ETFs were born as a variation on index funds, low-cost vehicles that make it easy for investors to track broad market moves. An investor in an index fund that tracks the S&P 500 buys a small amount of shares in all 500 companies. An ETF that tracks the index buys the same stocks but puts them in a pool and sells shares of that pool. That makes it easier to trade and brings tax advantages.

2. What’s an ETN?

ETNs also offer shares that track an index and are easily traded on exchanges, but that’s where the similarity to ETFs ends. ETNs are more like bonds -- unsecured debt obligations issued by banks, such as Credit Suisse Group AG and UBS Group AG. ETNs don’t own any of the securities in the indexes they follow. Similar to bonds, they have a maturity date. When that’s reached, the bank gives the holder cash based on the performance of the underlying index.

3. What are they used for?

ETNs are designed primarily for traders seeking to make easily unwound bets, often on assets deemed too volatile to be allowed into ETFs or in areas where markets are thin. They can also incorporate leverage -- that is, investors can secure returns two or three times above or below the underlying index’s. Investors who foresee a price swing in a particular sector can use ETNs to make large, leveraged short-terms bets. They have been a relatively niche product, reaching a peak of $16 billion in assets, compared with $5.4 trillion for ETFs. Banks make money on ETNs primarily through the fees they charge.

4. What are their advantages?

All index-based securities have to work to make sure that their values accurately reflect the value of the assets being tracked. ETNs usually have less of what’s known as tracking error because they don’t have an underlying portfolio of holdings that need to be bought, sold and rebalanced like an ETF. ETNs also have tax advantages because the holders are taxed only upon selling their shares, whereas ETFs’ total tax bill is more complicated, based on capital gains and losses.

5. What are the risks of an ETN?

Like all debt securities, ETNs come with an embedded credit risk -- that the issuing bank could default on the holding. The fate of an ETN is in the hands of the issuer in other ways, too. The holding’s value could decline based on a downgrade in the bank’s credit rating, even without a change in the underlying index. In addition, the issuer may not be able to repay the ETN when it matures or the issuer could close the ETN before maturity. If that happens, the holder would receive the market price, which could be lower than the initial purchase price. There’s also potential danger if banks decide to delist an ETN, preventing market makers from creating new shares. This often causes prices to become untethered from the index being tracked.

6. What problems have ETNs had recently?

When the stock market plunged in March and an oil price war upended asset prices, ETNs faced massive drops in value, and issuers like UBS were forced to close some of theirs. In August, a leveraged inverse natural gas ETN issued by Credit Suisse surged more than 6,000% in over-the-counter trading, walloping investors who had shorted it, whipsawing other traders and highlighting the dangers with such products.

7. What do regulators say?

The Securities and Exchange Commission and the Commodity Futures Trading Commission conducted reviews on ETNs tracking the VIX after volatility spiked and investors lost billions of dollars in 2018. In October, SEC Chairman Jay Clayton and several of his top deputies expressed concern over the growing involvement of retail investors, asking whether they understand the “unique risk” associated with leveraged and inverse exchange-traded funds and products. The SEC is reviewing existing rules regulating such instruments, he said.

8. What’s happening now?

More ETNs delisted or liquidated in 2020 than ever before, including a $1.5 billion volatility-linked product from Credit Suisse, two leveraged notes tracking mortgage real-estate investment trusts from UBS, and two leveraged oil notes offered by Citigroup Inc. The total ETN market in the U.S. currently holds about $5 billion in assets, down from $7 billion at the end of 2019. For investors who want unique exposures, the increasingly complex ETF universe now offers more kinds of products than ever before, which are often more straightforward and less risky than ETNs.

The Reference Shelf

  • An article from the time in March when the pandemic and an oil price war caused distress for exchange-traded products (ETPs).
  • How an ETN’s 6,000% price surge highlighted issues with the product.
  • SEC officials’ warning about risks of leveraged ETFs, ETNs and ETPs.
  • A look at how U.S. regulators scrutinized the implosion of investments that track volatility.
  • A QuickTake on bond ETFs.

©2020 Bloomberg L.P.

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