Should You Trust Your ETF?
July 18, 2012
I spoke about counterparty risk related to exchange traded notes in a recent blog. To be clear, July is not ETN-bashing month: ETNs offer distinct advantages over traditional ETFs in tracking, taxes and exposure.
But ETNs rise to the top of the heap when talking about risk in this context. ETNs are debt instruments, so if the issuing bank fails, ETN holders stand in line with the bank’s other debtholders to claim assets.
This means the entire value of your investment is at some risk—however small—if the counterparty fails.
Even here, however, the risk is mitigated. ETNs differ from other debt in important ways.
First, ETNs are publicly traded securities. That means you can sell them quickly if you feel the issuing bank is on the verge of a Lehman moment.
Second, ETNs can be sold back to the issuer at fair value, as long as the issuer is still afloat. But this can only occur in large share bundles, typically 50,000. And in both cases, a distressed environment will likely dry up liquidity with correspondingly higher transaction costs.
The structural risks discussed here are real, but they’re clearly defined, and most importantly, manageable.
So investors in exchange-traded products can exhale a bit.
While the wider world of finance is tainted by ethical lapses and worse, ETFs are designed to be transparent and, for the most part, that’s exactly what they are.