Open Letter to ETN Sponsors
Dear ETN Sponsors,
The time has come for you to address the ETN stigma. It is time to start moving the “unsecured debt obligation” structure of ETNs to something more appealing.
Investors often lump together the similarly-named exchange traded funds (ETFs) and exchange traded notes (ETNs). There are in fact major differences between these products, the most obvious being that ETFs are equity securities and ETNs are debt securities. Debt securities are typically senior to equity, and in the case of bankruptcy, it is usually better to be a debt holder than an equity holder.
That relationship is turned on its head in the world of exchange traded products. This is because ETFs are typically established as “investment companies” under the Investment Company Act of 1940, which makes them separate legal entities from their sponsors/managers. If a manager declares bankruptcy, a new manager can be hired to take its place. The assets of the ETF are separate from the failing company and still belong to the shareholders.
ETNs are not established as separate companies. They are instead an “unsecured debt obligation” of the issuer. See my earlier article “ETNs: Riskier than They Look.” Furthermore, the issuer of the debt cannot always be determined by the ETN’s name. A good example is Elements line of ETNs, which actually use four different issuers. My guess is that many investors who bought these products have no idea who issued the securities they own.
ETNs have some very useful features. They eliminate tracking error and can follow indexes that are difficult to access in ETF format. They are also potentially more tax-efficient in some cases.
The problem is that ETNs are “unsecured debt obligations” of the issuer. In the wake of high-profile liquidations like AIG, Bear Stearns and Lehman Brothers, investors can hardly be blamed if they are nervous at such an arrangement. To overcome this obstacle, sponsors must find a better solution. I will get the ball rolling by throwing out couple of suggestions.
One idea that I believe to be a simple solution, and one that will allow the industry to thrive, is to make ETNs “secured” obligations. For every ETN share that is created, why not escrow the money received against the bonds being issued? Rather than placing the proceeds from each sale of an ETN debt offering into some “general” fund, pledge them against the outstanding shares. They could even be invested in US Treasury securities if you really want investors to feel better about these products.
In reality, I believe the proceeds you receive are used to hedge your exposure to changes in value of the bond/index. However, that is probably accomplished in a highly leveraged fashion, leaving the bulk of the proceeds in cash. These hedges should be placed in escrow too, making ETNs into collateralized products. One downside to this approach is that when investors learn the details of how these products are hedged, the counter-party risks could make them even more nervous.
Another step might be to establish ETNs as separate entities, making them more like ETFs. Perhaps having ETNs insured is a potential solution, but that again involves additional counter-party risk. The bottom line is that you as ETN sponsors are receiving one dollar in cash for every dollar of ETNs sold. As a minimum, we as ETN investors would like to see the vast majority of that dollar pledged to the ETN we purchased.
Perhaps there are legal, accounting, or tax reasons why one or more of these approaches are not being used today. However, my guess is the current “unsecured debt obligation” structure was the quickest, easiest, and cheapest way to get these products to market. At the time, the idea of a company like Lehman Brothers declaring bankruptcy was unthinkable. Now reality has set in.
It is time for you, the ETN sponsors, to address the ETN stigma. I have offered a few suggestions, and I’m sure that others have ideas too.
On behalf of concerned investors everywhere,
Ron Rowland, ETN investor
Note: Current sponsors of US-listed ETNs include Barclays Global Investors, Claymore Advisors, Deutsche Bank, Elements Funds, First Trust Advisors, Goldman Sachs, UBS Global Asset Management, and Van Eck Global.