There are about as many different types of financial products out there as there are ways to skin a cat. Now I’m not really into skinning cats, but I do appreciate a good turn of phrase! So if you are interested in learning a little bit about two very popular types of investment products – ETFs and ETNs – please read on. Keep in mind, what you don’t know *CAN* hurt you.
I’m going to cut to the chase right up top – Exchange-Traded NOTES (ETNs) are, very simply, IOUs written by an investment bank. They are only as good as the bank’s credit. If the bank goes under, and you are holding its ETN, you can get in line with all of the other creditors and hope to get some portion of your money back when all the smoke clears a few years down the road when the bankruptcy proceedings are completed.
Keep in mind that ETNs are unsecured debts, so there is no collateral backing the note – nothing of value that creditors have a right to take ownership of in the event that the bank defaults. Also keep in mind, ETNs are junior in seniority – that means, a lot of other debts are going to get paid back in full, before you and your fellow ETN investors will get a chance to fight over the remaining crumbs.
In other words, if you are holding an ETN when its issuer goes belly up, your investment is very likely going to be worthless.
Now, Exchange-Traded FUNDS (ETFs) are set up very differently – they are not IOUs of a bank, and are not dependent on the credit of the issuing institution. They are designed to exist independently from the issuing entity. If the investment manager that is running a fund goes belly up, the fund investors still have a right to their respective portions of the fund assets. A new investment manager can be hired, or the fund shares can be redeemed for cash from the fund itself. I don’t mean to imply that would be a stress-free event for anyone involved, but the point is, the value of your ETF does not immediately go to zero if the issuing institution fails.
What if I Own ETNs?
Some of you may now be realizing, “Hey – Pro-Folio holds at least one ETN! Should I sell it and buy something else?” And you would be correct – DJP is an ETN issues by UBS. And yes, it is subject to UBS’s credit risk. If you would like to exit from the ETN and choose an ETF that is similar, you might look at USCI – United States Commodity Index Fund. USCI uses a somewhat different methodology that picks commodity futures contracts in part by choosing the contracts that have the least contango and greatest backwardation. (This is a discussion for a completely separate blog entry.) In theory, this methodology should prevent investors from losing as much money simply from contracts rolling forward from expiration to expiration over time. I am following USCI currently to decide whether to swap it into the Pro-Folio model in place of DJP. While credit risk is a factor, we also want an investment vehicle that will mirror the underlying index as faithfully as possible.
Where Can I Get More Information?
Thanks for spending a few minutes with Pro-Folio to learn about ETNs and ETFs. We’re one week from the March month-end trade instructions! See you then.