Nadig: Don’t Fear The ETN Bogeyman

ETNs look like they're getting traction, and for all the right reasons.

Bloomberg's Eric Balchunas is one of the smartest guys in the ETF business. Last week he wrote an excellent article on exchange-traded notes, highlighting the fact that several ETNs have been gathering a lot of assets lately, and waiving the caution flag in front of investors. It's "must" reading.

But I think Eric only gets it partially right.

First, let's look at how ETN flows have been going year-to-date. Through April 30, the 205 ETNs we track at ETF.com had pulled in a net $1.4 billion in new money. While $1 billion is a lot of money, consider that the other part of the ETF industry—the other 1,374 non-ETN products—pulled in $34 billion in new assets.

Let's look at the big winners on both tables. Here are the top ETFs in the four-month period:

The funds on this list are pretty vanilla stuff for the most part, with the exception of UWM, the ProShares Ultra Russell 2000 ETF (UWM). There are a few interesting tidbits, not the least of which is the presence of two S&P 500 ETFs on the list, while SPY, the granddaddy, has lost more than $16 billion so far this year. But that's another story.

Now let's look at the top 10 ETNs for the period:

The fact I had to make the table wider should be the first clue as to why Eric has a bit of agita about the growth here. These are complex strategies! Levered volatility? 3x inverse natural gas? Levered business development companies?

But there's some good news here: These are all investment approaches for which ETNs are an ideal structure. Because ETNs are simply debt notes with interesting payout patterns, essentially any measurable pattern of returns can be offered by a bank. Theoretically, Barclays could issue an ETN tied to the temperature in Las Vegas. The ETN doesn't "own" anything, so there's zero opportunity for any kind of tracking error. Its return is fixed, based on the math of the offering document.

What that means, however, is that it's extremely important for investors to actually read those offering documents, or at least do some basic research here on ETF.com and issuer websites to understand exactly what returns they should expect. Some ETNs have odd, path-dependent fees, and many ETNs are just flat-out expensive. DGAZ, the growth leader on the list above, costs 1.65 percent a year, or $165 for each $10,000 invested.

But expensive or not, once you know what you're buying, ETNs are extremely effective at delivering on their promises. They're basically taxed like stocks, which is a boon for any commodities-focused strategy; track perfectly; and while there is counterparty risk if, say, Credit Suisse goes bankrupt overnight, it's quite minimal and easily monitored. You can see our measurement of counterparty risk that we base on credit default swap rates, on any ETN page.

The ETN structure is particularly useful when the tax status, structure or liquidity of the underlying investment is complex, essentially washing away all that complexity for the individual investor and shifting it onto the issuing bank.

So when I see the list dominated by volatility business development companies, master limited partnerships and commodity-tracking strategies, I'm actually heartened. It means the structure is doing exactly what it's supposed to do, and investors are recognizing that.

Am I going to start recommending them to my mom? Of course not—I wouldn't do that any more than I'd recommend she plow all her money into, say, the triple-short Direxion Daily Russia Bear 3X ETF (RUSS) or the double-long ProShares Ultra DJ-UBS Crude Oil ETF (UCO).

In other words, let the exposure dictate your investment strategy, not some bogeyman of product structure.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].