Investment researcher Morningstar was out with warning Wednesday on hidden fees charged by exchange traded notes, or ETNs.
Some financial institutions have “inserted egregious features in the terms of many ETNs,” says analyst Samuel Lee.
“The worst we’ve identified so far is a fee calculation that secretly shifts even more risk to the investor, earning banks fatter margins when their ETNs suddenly drop in value,” the Morningstar ETF analyst wrote in an article Wednesday.
ETNs are often grouped together with exchange traded funds, or ETFs, but Lee says the comparison is inappropriate.
Unlike exchange traded funds, an ETN is essentially an uncollateralized loan to an investment bank, with introduces credit risk. “ETNs are not registered under the Investment Company Act of 1940, or the ’40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures,” he wrote.
The fee calculation that “set a disturbing standard” is known as path-dependent fees. “which create tracking error to the index depending on the index’s path.”
The two largest ETNs, JP Morgan Alerian MLP Index (NYSEArca: AMJ) and Path Dow Jones-UBS Commodity Index Total Return (NYSEArca: DJP), use path-dependent fees, according to Morningstar.
Other examples of extra fees that ETNs can charge include event risk hedge cost, futures execution cost and index calculation fees.
“When many players in the industry behave in ways that signal they can’t be trusted, it raises questions about all ETNs. What a shame. The best ETNs can be truly useful tools, fulfilling their promise of tax efficiency and perfect tracking,” Lee wrote.
“The ETN industry has gotten away with such investor-unfriendly behavior by free-riding the goodwill conventional ETFs have created as simple, low-cost, transparent, tax-efficient products. Understandably, many investors have taken for granted that the ETNs’ headline fees are calculated just like expense ratios, that ‘gotcha’ fees are not facts of life,” he concluded. “It’s a lot easier than combing through hundreds of pages of a prospectus. Given how publicly accessible ETNs are, buying one should not be an exercise in legal minesweeper. Until this situation changes, caveat emptor.”