Lending to your ETN; Global Improvement

When is the last time you took out a loan? Chances are the application process required tons of paperwork and financial disclosures on your part. If the loan was for the purpose of buying something, such as a car or home, then you also had to hand over that purchase as collateral to “secure” the loan.

Banks make you jump through many hoops before they lend you any money, and then they want something in return—guaranteed monthly payments plus interest, and the ability to repossess the object of the loan as a way to enforce that guarantee.

What happens when the roles are reversed? If a bank wants to borrow money from you, do you put the bank through a similar wringer? If you are one of the thousands of people that have lent money to a bank by purchasing one of its ETNs, then the answer is probably no. Let me explain.

Exchange-traded funds (“ETFs”) and exchange-traded notes (“ETNs”) are similar in many ways, but they have major differences as well. When you buy an ETF, you receive an ownership stake in a pooled investment, structured as an independent entity. However, when you buy an ETN, you are lending your money to the issuer. All you own is an IOU, and the identity of “I” and “U” may not be entirely clear.

Although often glossed over, the offering prospectus for ETNs typically state that it is an unsecured debt obligation of the issuing bank. The issuer will often include the word “senior” in that disclosure to make you feel better, but it is not something that will help you much in the case of default. In other words, ETNs are a “promise” to repay the money borrowed, but ETNs do not own anything, are not collateralized, and are not segregated from other debts and obligations of the borrowing bank.

If this sounds different from ETFs and mutual funds, you are correct. ETFs and mutual funds are fully collateralized stand-alone entities, independent of the sponsor, issuer, and manager. If one of the previously mentioned parties goes out of business, through bankruptcy or more graceful terms, then another company can step in and take its place. The fund itself is not affected.

Therefore, when you buy an ETN, you are lending money to the issuing bank without any collateral. Another important but often overlooked point is that the issuer may be different from the ETN’s sponsor and may not be identified in the product’s name. Therefore, it may not be obvious who or what you are lending your money to.

Occasionally, identifying the issuer is a straightforward process: Morgan Stanley (MS) issues the Morgan Stanley brand of ETNs, and Deutsche Bank (DB) issues the DB ETNs. Some firms use brand names. iPath ETNs are from Barclays (BCS) and ETRACS are issued by UBS (UBS). Some banks issue ETNs under multiple brands. For example, Credit Suisse (CS) issues ETNs under the Credit Suisse name, its own CS X-Links brand, the ELEMENTS brand, and as VelocityShares.

If that is not confusing enough, some brands are used by multiple issuing banks. For example, ETNs issued by Credit Suisse, Deutsche Bank, Swedish Export Credit, and HSBC have all come to market under the ELEMENTS brand. Credit Suisse issues most of the ETNs under the VelocityShares brand, but some are issued by Citigroup, and these are separate from Citigroups’s own C-Tracks brand of ETNs.

Once upon a time, all these banks were considered too big to fail. All that changed in 2008 when Lehman Brothers declared bankruptcy and the owners of the Opta brand of ETNs it had issued were left holding the bag. Last year, the financial viability of Deutsche Bank came into question, putting a dark cloud over its ETNs. In November, Credit Suisse started taking successful products off the market in an apparent attempt to shore up its balance sheet. If you are lending money to Credit Suisse, then that should make you nervous.

Before you buy an ETN, you need to do a few things: Know who the issuing bank is. Have a plan to monitor the credit worthiness of the bank. Have an exit plan if the bank’s debts are under scrutiny. Have an exit plan if the ETN does not perform as expected. Execute your plan.

Real Estate was the top-performing sector and posted the largest gains in both momentum and ranking position. All factors lost momentum, but the majority of global categories improved.

Sectors: Real Estate and Telecom were the top-performing sectors over the past week, which moved Real Estate two places higher and into a positive momentum reading. Meanwhile, Telecom was already holding down the second-place spot, and its gains allowed it to secure a tighter grip on that position. Financials is still the top dog, with the smokestack sectors of Energy, Industrials, and Materials rounding out the top five. There was some minor shuffling of positions among the lower-tier categories. Utilities lost momentum but still managed to move up a spot in the rankings due to the larger drop for Consumer Discretionary. Health Care remains on the bottom and has the dubious honor of being the only sector currently registering negative momentum.

Factors: All factors lost momentum the past week as the market took advantage of the holiday-shortened week to digest some of its recent gains. The top five factors are the same for a third consecutive week. High Beta extends its reign, with Small Size, Value, and Fundamental factors falling in line below it. The four mid-tier categories of Market Cap, Yield, Dividend Growth, and Quality remain tightly bunched and somewhat isolated from the higher- and lower-ranked factors. Growth and Momentum swapped places on the bottom, but both continue to lag the field.

Global: Four global categories remain in the red, although not the same four as last week. Latin America made the transition to green while Japan went the other direction. The U.S. is on the top for a third week, and the Eurozone is holding down the #2 spot for a second week. Canada moved ahead of World Equity as it benefits from stability in the oil patch and gains for the Canadian dollar. Unlike the sector and factor rankings, where most categories lost momentum over the past week, the majority of global categories posted improvements. This is especially visible among the lower-ranked members, where three are on the verge of moving into the green. China also had a good week, but it is still firmly in last place.


Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.


“Before borrowing money from a friend it’s best to decide which you need most.”

—Joe Moore

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