It’s Time For An ETF Gate

March 29, 2012




But then there are ETNs. I’m actually a fan of ETNs in general: Perfect tracking and fantastic tax treatment in exchange for a little counterparty risk is a trade I’m willing to make. The problem is that ETNs live in an extremely gray area of the market.

There are two unique things about ETNs that mean they should be behind the gate, regardless of whether the pattern of returns promised is something as simple as the S&P 500 or as complex as TVIX.

The first is counterparty risk. ETNs, because they’re debt, could technically be defaulted and become worthless. This means they should trade at a slight discount to compensate for that risk. But they don’t.

Interestingly, some academic finance wonks are in the process of figuring out that little mystery. It’s not an enormous risk—the only people to ever lose their ETN shares in bankruptcy were the last-ditch holders of the Lehman Opta ETNs, and even they got pennies on the dollar eventually.

The second—and this is much more important—is informational risk. By that I mean the risk that you’re not actually buying what you think you’re buying. I’d argue that this is present in mutual funds, insurance products and plain-vanilla ETFs as well.

But in ETNs, it can be exceedingly difficult to actually figure out what you should rationally be expecting. ETN pricing supplements look nothing like a traditional fund prospectus, and the words used to describe fees and expenses are entirely alien to a die-hard fund investor.

To make matters worse, because most ETNs are issued under blanket registrations, there’s very little actual Securities and Exchange Commission oversight on what’s promised in the ETN documentation.

Yes, there are basic requirements that have to be met for any bond issuance, but there isn’t any boundary on what pattern of returns can be promised.

There are no limits on “derivative exposure” or shorting or anything else, because the ETN simply doesn’t hold anything. You could quite literally launch an ETN indexed to my age that would reset to zero on my death, creating a virtual chicken version of a “Dave Nadig Death Pool.”

This leads to all sorts of interesting quirks, like the path-dependant pricing of many ETNs recently highlighted by Morningstar, or the “Event Risk Weekly Hedge Cost” for the short Volatility ETNs from UBS—a surprise 4 percent annualized fee to someone who isn’t paying attention.

Unless the SEC radically alters the structure under which ETNs are reviewed, which seems exceedingly unlikely, that means ETNs as a class probably need to be behind the gate too.

Lower The Gate

I’d like to think people actually learn about their investment vehicles before they purchase them.

But I’m not that naive. ETNs like TVIX or ETFs like UVXY or the United States Natural Gas Fund (NYSEArca: UNG) do indeed have special risks.

These are special risks you can only find out about by doing some serious proactive digging.

It’s not that the products don’t work. It’s that the distribution system doesn’t.


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