Exchange traded notes (ETNs) took a beating in the global credit crisis of 2008, not only in terms of performance alongside the broader market, but on a public relations front as major investment banks crumbled. Those days are fast becoming a distant memory.
Just one year ago, assets in the ETN industry totaled just under $5 billion. Today, they’ve ballooned up to $9.7 billion.
Chris Yeagley, the U.S. head of equity structured products at UBS, credits the ETN revival with a slew of innovative new offerings and the fact that investors have become more comfortable with bank credit risk.
Misunderstood Credit Risk
Oft-cited in stories about ETNs is that they’re debt issued by banks – if the bank goes under, you’ll have to take your place in line with the other creditors and wait for your payment. As big Wall Street Banks collapsed or were gobbled up by other banks in late 2008 and early 2009, investors became aware of this heightened risk and shunned the instruments. [Everything You Want to Know About ETNs.]
It’s true that the collapse of an issuing bank is still a risk, but the market’s perceived risk of this occurring has declined significantly from where it was a year or two ago. While the overnight collapse of a big bank like Lehman Brothers and Bear Stearns is still a worst-case scenario, a more likely scenario for a troubled bank today is that it would go through a series of credit rating downgrades prior to bankruptcy. This is where ETNs offer some measure of protection.
ETNs possess a feature that allows investors to redeem them at net asset value on a daily or weekly basis. That means that if, for example, a bank that issues an ETN were to be downgraded, investors would have the right to redeem it at NAV, which is independent of credit quality, and thus not feel the pain of the downgrade. [Turmoil Gives VIX ETNs Their Moment.]
ETFs vs. ETNs
Rather than rivals, Yeagley sees ETFs and ETNs as complementary products. “I do think that all things being equal, there are benefits and disadvantages to both.”
The downside of ETNs is the credit risk, which doesn’t appear in ETFs unless it holds an uncollateralized swap. [MLP ETNs: Another Source of Income?]
But the benefit of ETNs is that they don’t have any tracking error – they deliver the direct return of the index minus a fee. In addition, there are a number of products that can be brought to market as an ETN, but not as an ETF because of any number of factors – ‘40 Act restrictions, inefficient taxation and so on.
The Future of the Industry
Overall, Yeagley is pleased with how the industry has recovered from the troubled Lehman era – he estimates that ETN assets are at about 75% of where they would have been had the bank not collapsed.
Innovation should be coming ahead for the industry, as well. ETNs have a lower fixed cost than ETFs, therefore, ETNs don’t have to achieve the same level of assets under management in order to be economically viable for their sponsors. The general belief in the ETF industry is that a fund needs to hit at least $100 million in assets to be profitable. [ETN Is Another Way to Get Your Commodity Fix.]
Because ETNs have lower asset hurdles, issuers can be more aggressive in the products that they bring to market.
“More innovative products will come out in the ETN space,” Yeagley says. And by allowing big investment banks participate in the exchange-traded product market, “you’re increasing the number of competitors, which is always good for investors.”
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