Unlike exchange-traded funds (“ETFs”) and mutual funds, which are legally structured as stand-alone entities, exchange-traded notes (“ETNs”) are debt obligations of the issuer. What is more, they are “unsecured” debt obligations without any type of collateral. Therefore, ETNs carry an additional risk, a risk that would be realized if the issuer were to default or declare bankruptcy.
This risk was overlooked in the early days of ETNs for a couple of reasons: (1) Such a default had never happened, and (2) the issuers were banks that most investors considered to be “too big to fail.” Then along came the financial crisis and the collapse of Lehman Brothers. Lehman was the issuer of three U.S.-listed ETNs under the “Opta” brand, including the Opta S&P Private Equity ETN (former ticker PPE). When Lehman declared bankruptcy eight years ago, owners of the three Opta ETNs were left holding the bag.
Today, Deutsche Bank (DB) is the issuer of 20 ETNs currently offered to U.S. investors, although only 19 of them are listed for trading. Over the past week or so, legitimate concerns about the financial viability of DB have surfaced. Its stock has plunged 19% in eight trading days, surpassing the 2008 financial crisis low. The company faced credit rating downgrades earlier this year, the U.S. Justice Department is seeking a $14 billion settlement related to mortgage-securities investigations, and the German government is getting nervous. DB probably falls into the “too big to fail” bucket among European financial institutions, but what if it’s not? If DB has borrowed money from you, then you should be concerned. If you own DB ETNs, then DB has borrowed money from you, and your loan to DB is not secured with any collateral.
Your best recourse at this time is to sell your DB ETNs before such a risk materializes. On August 31, DB was the issuer behind 28 ETN listings on U.S. markets. DB “called” eight of them for redemption, with their last day of trading occurring on September 19. Additionally, the NYSE forced the delisting of the DB Base Metals Long ETN (BDG) after the market closed on September 16 because it had less than $400,000 of assets. Unfortunately, DB has not announced any plans or intentions of redeeming the BDG notes and returning the money to the noteholders. Instead, owners will have to find a buyer in the unlisted over-the-counter market for ETNs. Good luck with that.
It should be relatively easy to dispose any of the remaining 19 listed ETNs. Together, they hold about $727 million in assets, with nearly half ($351 million) in the Deutsche Bank FI Enhanced Global HY ETN (FIEG). This ETN was a custom creation for Fisher Investments, and I presume that Fisher then placed the shares into its clients’ accounts. If so, then Fisher controls the decision of what risk mitigation steps to take regarding these particular ETNs.
The next largest DB ETN is the DB Gold Double Long ETN (DGP) with $144 million in assets. I would recommend that owners of this product replace it with the ProShares Ultra Gold ETF (UGL), which also offers 200% exposure to gold bullion but in a much safer ETF wrapper. Next in terms of assets is the DB Crude Oil Double Short ETN (DTO) with $70 million. Here, the ProShares UltraShort Bloomberg Crude Oil ETF (SCO) offers safer exposure. The only drawback to the replacement ETFs I have suggested is that they issue K-1 statements instead of 1099s for tax reporting. For investors that are used to dealing with K-1s, it is not big deal, but competitors and the financial media have done their best to scare investors.
There are suitable replacements for many of the other DB ETNs, and resources such as the ETF Field Guide can help you locate and evaluate them. By the way, all of the DB ETNs are “broken products” and are identified as such in the ETF Field Guide. A broken product is one where the creation mechanism is not functioning. This makes it difficult to impossible for market makers to keep the trading prices in line with the underlying net asset values. Consequently, it is imperative that you use a limit order when selling your DB ETNs. The good news is that the credit worthiness of the issuer is not a factor in calculating the net asset values of ETNs. Therefore, if you can sell your DB ETNs at a price close to the net asset value, then you should be getting a fair deal.
The rise of the higher-yielding sectors was the predominant theme this week. Utilities, Real Estate, and Telecom all surged substantially higher on a relative strength basis. Utilities shed its negative momentum and climbed two spots to secure second place. Real Estate surged from 10th to third on a 17-point momentum improvement. Telecom posted a 3.3% gain this past week, the best performance among our 33 categories, and climbed from last place to seventh in the rankings. Most of these gains are the direct result of the Fed’s decision to leave interest rates unchanged at last week’s FOMC meeting. With bond yields remaining low, bonds are unable to provide any new competition to these dividend-paying stocks. Technology extended its leadership reign to eight weeks and widened its margin over the other sectors. Health Care slipped a spot, and Industrials held steady in fifth, although both posted momentum gains and moved from red to green. Financials was the only sector to lose ground this past week, causing it to drop four places to sixth. Consumer Staples slipped a spot and Energy dropped from eighth to last. They are the only two sectors currently registering negative momentum.
The inverse-capitalization alignment continues to persist in the style rankings despite the small-cap swoon earlier in the month. In fact, Micro-Cap and the Small-Cap threesome widened their lead over the rest of the style categories this week. Micro-Cap is at the top for a fourth week, with Small-Cap Growth, Small-Cap Blend, and Small-Cap Value firmly occupying the next three slots. Mid-Caps jumped ahead of most of the Large-Caps, with Mid-Cap Value moving four places higher to fifth, Mid-Cap Blend posting a three-spot improvement, and Mid-Cap Growth climbing from the basement to eighth. Large-Cap Growth managed to hang on to its sixth-place ranking this week, but the other Large-Cap categories fell lower. Mega-Cap dropped from fifth to 10th, Large-Cap Blend slid two spots lower, and Large-Cap Value fell from eighth to last.
China was the only global category unable to post a momentum improvement this week, but its hold on the top spot in the rankings is still intact. Japan had a large boost in momentum, allowing it to climb another step higher. Japan’s ascension pushed Emerging Markets down to third. Pacific ex-Japan surged from last to fourth a week ago and didn’t concede any of its newly acquired status this past week. Latin America partially bounced back from its recent setback and moved four places higher to fifth. EAFE edged a step higher, while World Equity, the U.S., and the Eurozone all slipped lower. Canada and the U.K. swapped positions with the U.K. landing on the bottom this week. All global categories have now moved back into the green.
“Deutsche Bank appears to be the most important net contributor
to systemic risks in the global banking system.”
—International Monetary Fund report dated June 2016
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