published Wednesday, September 28th, 2011

Personal Finance: Exchange-traded notes can carry extra risk

By Travis Flenniken

Exchange-traded notes offer investors the opportunity to create strategies for diversifying their portfolio and pick up profits from trends they see in the market.

For example, if an investor thinks the price of crude oil will rise, he can buy an ETN that will track the price of oil.

Or perhaps an investor believes that the market will be volatile, purchasing an ETN that tracks the VIX index in hopes it will pay off from big swings in the market. There also are ETNs that track traditional investments methodologies, such as the "Dogs of the Dow" investment strategy.

Exposure to European banks

While ETNs may be compelling investment vehicles to some, investors should understand that ETNs have an added layer of risk -- credit risk.

An ETN is essentially an unsecured loan to a financial institution. Four of the top five issuers of ETNs are European banks. This is particularly relevant and alarming because of the potentially toxic credit environment in Europe.

ETNs are not the same thing as exchange-traded funds. Although they share some of the same characteristics, they have very big differences.

ETFs offer investors an interest in a pool of securities in much the same fashion as a mutual fund. Like a mutual fund, the price of the ETF changes with the value of the underlying securities, which could be stocks, bonds, real estate, gold, etc. Many ETFs will track an index such as the S&P 500 or the Russell 2000.

ETNs are similar to ETFs in that they can be traded intraday, sold short and will typically track an index. ETNs, however, do not hold a basket of securities, but rather they are unsecured loans to the issuer. The issuer of an ETN is typically a financial institution that is obligated to repay the loan at maturity and must provide the lender (the investor) a return linked to the performance of the underlying benchmark, net of fees.

Investors of ETNs are effectively making an unsecured loan to an institution in exchange for their commitment to provide a return tied to an index. Large issuers of ETNs include Barclays Bank, which issued the first ETN in 2006 under the iPath brand, BNP Paribas, UBS, Goldman Sachs and Credit Suisse.

The implication of this structure is that even if an investor is right about the merits of the underlying investment -- natural gas, soybeans, gold, whatever -- all could be lost if the issuer of the ETN goes out of business.

Investors in the Opta ETNs felt the pain in 2008 when Lehman Brothers folded. Opta ETNs were tied to various indices, including ones linked to agricultural commodities such as corn, soybeans and wheat. Despite the performance of commodities underlying the index, trading of the Opta ETNs was halted and the notes were ultimately delisted when the bank failed, leaving investors with nothing.

There is a tremendous amount of uncertainty in the European Union related to the stability of the banking system. While most believe it's only a matter of time before Greece defaults, no one knows how a default will affect the banking system in that region. If Europe falls into a credit-crises scenario similar to the one in the U.S. in 2008, it is possible that investors of ETNs issued by a European bank may suffer the same fate as those that held Lehman Brother's Opta ETNs.

Investors in ETNs should take a good look at their investment to make certain they are comfortable with the creditworthiness of the issuer. And as always, steer clear of investments that you don't understand.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -- demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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