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The Downside of an Exchange Traded Note (ETN)

Written By Geoffrey Pike

Posted February 1, 2016

betnAn oil ETN has recently demonstrated some of the risks of owning an ETN. The IPath oil ETN issued by Barclays dropped by 17% in one day.

An Exchange Traded Note (ETN) is somewhat similar to an Exchange Traded Fund (ETF). But an ETN has some similar characteristics to a bond as well, where the buyer can redeem the principal upon maturity.

ETFs have been very successful in the financial markets. They provide opportunities to investors in buying into certain indexes and industries that previously weren’t available.

For example, in the past, if you wanted to own gold, you had to either buy physical gold or find a company to buy certificates that would represent gold in a warehouse. The other option was to enter the futures market. But with the creation of a gold ETF (GLD), investors with a basic brokerage account could finally easily trade paper gold (or perhaps more accurately, digital gold).

This oil ETN is issued by Barclays. There was trouble brewing with this ETN when it was trading at a 36% premium to its fair value, as reported by Zero Hedge.

The problem arose because Barclays was limiting the number of new shares that could be created. This means that the shares could not stay in line with the oil market.

ETFs and ETNs work differently than say, a stock. They also work differently than a currency that is created by a central bank. In the case of ETFs and ETNs, the number of shares need to be allowed to increase or contract based on buying and selling as compared to the index it is trying to track.

By limiting the number of shares created with its oil ETN, Barclays was overvaluing the trading price. In normal circumstances, if shares are trading at a price that is higher than the market value of the asset it is tracking, then new shares should be created to accommodate this demand. In reverse, if shares are trading below the underlying asset, then the number of shares should contract.

In other words, when you buy an ETN, you are really at the mercy of the issuer to allow the number of shares to fluctuate in order to reflect the price of the asset that the ETN is tracking.

Trusting a Third Party

ETFs are similar to ETNs, but there are some key differences. With an ETN, you are buying an unsecured debt instrument. It represents a promise to pay you a certain amount that will typically correspond to the asset that it tracks. But it is similar to a bond because you are dependent on the issuer.

For example, if you buy an oil ETN from Barclays and Barclays were to go bankrupt, then your investment would likely go bankrupt with it. (Of course, a major financial institution would probably get bailed out.)

When you buy an ETF, you are buying an underlying asset or group of assets. Your shares represent a certain amount of oil, or gold, or whatever it is that the ETF tracks.

ETNs should actually be more precise in the returns corresponding to the index that it seeks to track. But as we saw in the case of this Barclays ETN, you are more vulnerable to shenanigans.

It is not that ETFs are without risk. In fact, since their very inception, some people have been skeptical of them. In the case of gold, there is always a question of whether there is adequate gold in the vaults to represent the outstanding shares. In addition, ETFs often have difficulty in precisely corresponding to the assets/ indexes that are being tracked.

Still, with this latest story, it confirms my point of view that I prefer ETFs to ETNs. Any financial investment that is done with electronic digits has its vulnerability. If you want to invest in gold, your only guarantee of actually owning the gold and not worrying about someone else defaulting is by owning the physical gold.

In the case of oil, you probably don’t want to store barrels of oil in your garage, so you are pretty much stuck with financial instruments. But even buying shares of a company’s stock puts you in the same position.

The key here is diversification and common sense. I very much appreciated when the first gold ETF was released. It gave investors more options than they previously had. If you want to buy and sell gold on a regular basis, physical gold is not optimal for this. The transaction costs are too high. There are also other issues you face.

If you want to buy gold and then sell it the next week, then an ETF is probably the way to go. With an online brokerage account, your trading costs will be minimal.

You should never trust any one investment with your money. That is why you diversify. Still, I have avoided ETNs up until now and I will likely continue to do so, especially with this latest story. There are other ways to buy oil. You can also buy energy stocks. There will likely be a good time to buy in the energy sector in the not-so-distant future.