Open Letter to ETN Sponsors

June 12, 2009 by  
Filed under Commentary, ETFs, ETNs

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.

Comments

3 Responses to “Open Letter to ETN Sponsors”

  1. Bo Shi on June 22nd, 2009 7:26 am

    Hi Ron,

    Please allow me to tell you my situation and I greatly appreciate your commnets about how I should handle it.

    Back in 2007 I purchased 50 shares of BSR and hold it till now. However, it was delisted on 6/15/09. I don’t know the news release (copied below) by JPMorgan. As you know, BSR was issued by Bear Stern and now it is a part of JPMorgan. You can see the copied news release from Yahoo after typing BSR. My discount broker now assigned a new symbol “ARCX” for BSR, which is zero value in my account because it is not traded.

    I contacted a person at Bear Stern, which is a division of JPMorgan, about how to handle it. I was told to open an account at Bear Stern and transfer 50 shares of BSR from my discount broker to the new account in order to sell it. However, Bear Stern doesn’t send me any application forms yet after that phone conversation.

    From the news release, it looks like it is not liquidating BSR. I don’t know how to get some of my investment back.

    I also called JPMorgan using the phone number listed in the news relase. I was given another number for the call, but it never calls me back. What is your view?

    Thanks, Bo

    NEW YORK–(BUSINESS WIRE)–JPMorgan Chase & Co. will withdraw the NYSE Arca listing of its BearLinxSM Alerian MLP Select Index ETNs (Ticker: BSR ) effective on or about June 15, 2009. The BearLinxSM ETNs had been periodically issued by The Bear Stearns Companies Inc. prior to, but not after, JPMorgan Chase’s acquisition of Bear Stearns. The listing is being withdrawn given the current limited availability of the security.

    Upon the effective delisting date, the BearLinxSM ETNs will no longer be listed on any national exchange or quoted medium. The BearLinxSM ETNs may trade, if at all, on an over the counter basis.

    The JPMorgan Alerian MLP Index ETN (Ticker: “AMJ”), which offers exposure to the MLP sector through the same index, is unaffected and remains listed on NYSE Arca.

  2. Ron Rowland on June 22nd, 2009 4:05 pm

    Bo,

    Thanks for bringing this to my attention and sorry to hear about the problems it is causing you. I have written a new article on the subject. Here is the link…
    http://investwithanedge.com/shareholders-left-hanging-with-bsr-delisting

    Ron

  3. Keith Styrcula on September 2nd, 2009 9:10 am

    The fact that it is no longer listed should not inhibit your ability to liquidate the notes. Call the JPMorgan trading desk in New York directly at 212.270.6000 and ask for the Structured Investments group.