ETNs & Leveraged ETFs
Exchange Traded Notes: Not Like Most ETFs
Although exchange traded notes (ETNs) are exchange traded, ETNs aren’t registered as funds under the Investment Company Act of 1940, and they are not baskets of stocks or securities replicating an index.
Instead, ETNs represent a general obligation of the issuer (or some other named counterparty) who promises to deliver the return of some index. This introduces significant counterparty risk, without any clear collateral requirement and with no limit on leverage. Worse, if the issuer loses its credit rating or is insolvent, investors have no recourse (basically you are a bond-holder).
If this sounds far-fetched, consider that Lehman Brothers issued ETNs less than 3-weeks before declaring bankruptcy in 2008, leaving investors holding a product that was no longer liquid and was now an obligation of a bankrupt counterparty.
Contrast this with a mutual fund or ETF: a mutual fund or ETF is a segregated portfolio that holds a basket of securities (including cash). In the event that a service provider declared bankruptcy, the fund’s board could hire another provider or liquidate the fund and all shareholders would be redeemed at the current NAV. ETNs do not have this protection.
By limiting our universe to ETFs and mutual funds, we may miss some opportunities that are offered only through ETNs. We are willing to reconsider ETNs if new regulations will better protect investors from counterparty credit risks.
Additional Risks of Leveraged ETFs
We believe that the potential benefit of leveraged ETF is generally outweighed by risks. Much has been written about tracking error and poor long-term performance of leveraged ETFs. What many fail to recognize is that most leveraged ETFs get their index exposure through swap agreements (in other words, a counterparty agrees to provide leveraged exposure to the index for a fee).
Leveraged ETF providers manage this risk by spreading investments among several swap counterparties, and holding collateral. Still, the pool of swap counterparties is limited (Lehman Brothers and Bear Stearns are no longer available) and there is no standard to measure how a swap dealer is hedging its exposure.
Also, leveraged ETFs are extremely volatile. A “normal” trend in an underlying index includes both up and down moves. Mixing leveraged and unleveraged funds in the rankings increases the volatility of the rankings of the unleveraged funds (as leveraged alternatives bounce up and down) and the losses one takes when whip-sawed can be devastating.