What is an ETN?

You may have heard of ETN’s. I keep hearing the term being thrown around all over the place but I never see it defined. So what is an ETN?

“ETN” stands for Exchange Traded Note. It sounds similar to an ETF (Exchange Traded Fund) but it is very different. When you pick an ETF it owns shares – all the shares – of the stocks that make up an index. An ETN doesn’t own anything. It is actually just a promise by the company who issues it to give you the same returns of an index minus the fees.

What’s the problem with ETNs?

Where do I start? These are unsecured debt securities (like bonds) that track an index as I’ve explained. You could classify it in the equity asset class but it’s not so simple.

It’s a pretty sophisticated instrument designed to make Wall Street money and one that could cost you a pile of cash. Wall Street makes money because they get the fees of course. And it’s far cheaper to run an ETN than an ETF. An ETN doesn’t own the actual securities. It is a derivative instrument. It may own puts and calls so it invests a tiny fraction of the money that it collects. As a result, it has more money working that makes the issuer money.

The problem isn’t so much that Wall Street makes money with these investments. The problem is that you take a big risk when you buy them. In fact, in the last month, ETNs owned by Credit Suisse Group AG and Barclays PLC cost investors a fortune.

What happened was the shares began to trade at steep premiums. That’s because there was a great deal of speculation and demand for those shares. As a result of the juicy premium, the issuers then created more shares and flooded the market. Of course, as a result, the shares plummeted and many investors saw their accounts lose over 50% as a result.

The companies who issued this securities didn’t do anything wrong or illegal. The problem was that investors ignored the fact that these securities can trade at big discounts (or as in this case) premiums to the value of the security. So the ETN itself may work just fine but because the market may be extremely over or under valued, the investment itself could punish investors.

In other words, the banks that issue the ETN may indeed provide what they promise. But the market may throw the value of the shares of that ETN all over the place. Most people who buy these securities fail to understand that ETNs trade at discounts and premiums. As a result, even very smart people lose money in the market everyday.

This is very similar to how a stock works. The value of a company may be one thing. But the value the market places on the company at any one time could be something completely different. Investors are often shocked when the market places a value on the company that is far different from the value they place on it.

How bad could it get with ETFs?

Let’s take an example. Consider Barclays Natural Gas ETN (GAZ). People went bonkers over natural gas this year and the premium almost reached 100%. That means people were paying $2 for every $1 of value. Not a good way to make money…right?

Indeed, whenever a certain sector of the market gets very hot you are going to see the ETNs start acting strangely. And that is precisely the time when novice investors will start getting in. Unfortunately, reality sets back in. The stock price comes back down to earth and the novice investors get buried.

The Solution

If you insist on buying ETNs make sure to check the premium or discount. You can do so by simply going over to Morningstar.com. Look at the example below.

As of the date of the screen shot, this ETN was trading at a 116% premium. The value of the shares was $1.87 but the shares were trading at $4. This would be a great ETN to avoid. Right?

Bottom line – I am not a fan of ETN’s. These are for speculators – not investors. It’s nice to make fast money but the risks are often far higher than you identify. Rather than speculate, work out a long-term investment strategy and stick with it.

Have you purchased ETNs? What was your experience?