ETNs - is this really what they are!?? (E-Trade, fund, trading)

[sonarrat]

Originally Posted by E*Trade

Exchange-traded notes ("ETNs") are unsecured, unsubordinated debt obligations of the company that issues them and have no principal protection. Although an ETN’s performance is contractually tied to the market index it is designed to track, ETNs do not hold any assets. Therefore, unlike investors in exchange-traded funds ("ETFs"), which hold assets that could be liquidated in the event of a failure of the ETF issuer, ETN investors would only have an unsecured claim for payment against the ETN issuer in the event of issuer's failure. Before investing, please carefully consider the credit worthiness of the ETN issuer and the ETNs investment objectives, risks, fees and charges.

Is this for real? A contract with a bank that it must pay you what the stock is worth, but without any obligation to invest the money in a way that guarantees they can repay their debt? What?!? Am I the only one who thinks this is not merely disingenuous, not merely dangerous, but in fact utterly insane?

The largest and oldest ETN is DJP, a commodities broad basket fund. I just spent hours on Barclays' website for the fund trying to find any evidence that they actually invest in a way that guarantees they can pay out what they're promising (less the 0.75% annual fee due at redemption). After all, you never know when an investment is going to suddenly move, causing you to miss the boat if you weren't ready for it. Here's what I found:

Originally Posted by DJP Prospectus

In anticipation of the sale of a series of Securities, we or our affiliates expect to enter into hedging transactions involving purchases of instruments linked to the Index underlying those Securities prior to or on the inception date. In addition, from time to time after we issue a series of Securities, we or our affiliates may enter into additional hedging transactions or unwind those hedging transactions we have entered into. In this regard, we or our affiliates may:

• acquire or dispose of long or short positions in listed or over-the-counter options, futures, or other instruments linked to some or all of the index components (including the underlying physical commodities) or Indices;

• acquire or dispose of long or short positions in listed or over-the-counter options, futures, or other instruments linked to the level of other similar market indices, contracts or commodities; or

• any combination of the above two.

We or our affiliates may acquire a long or short position in securities similar to a series of Securities from time to time and may, in our or their sole discretion, hold or resell those securities.

We or our affiliates may close out our or their hedge positions on or before a final valuation date. That step may involve sales or purchases of listed or over-the-counter options or futures on index components (including the underlying physical commodities) or listed or over-thecounter options, futures, or other instruments linked to the level of index components or the Indices, as well as other indices designed to track the performance of the Indices or other components of the commodities market.

The hedging activity discussed above may adversely affect the value of an Index and, as a consequence, the market value of the Securities linked to that Index from time totime and the amount payable at maturity or upon redemption. See “Risk Factors” in this pricing supplement for a discussion of possible adverse effects related to our hedging activities. [bolding present in prospectus]

That doesn't sound to me like they're trying to replicate the index with the money we pay them or even make any money. For all we know, they could be intentionally pissing away their money in ill-advised positions which will deplete their funds and cause them to lose money when it comes time to pay out in 2037. They get a license to mess around and take risks, and if they get themselves into a bind, as Lehman Bros. did, then suddenly you're trying to get your money back in bankruptcy court.

I honestly can't imagine how these things could be getting any traction in the market.

[mtta]

It's not really necessary that they try to replicate the index with the money we invest in them - the results of the index are the results of an ETN, less the expense ratio (.75%). There can sometimes be a very small discount or premium due to the supply and demand fluctuations on the exchanges.

You're right that there is an issuer risk - if it were possible for Barclay's to go bankrupt, there would be nothing behind the curtain. I don't personally believe Barclay's, HSBC, DB, or a bank of similar caliber would be allowed to fail - and the exchange traded funds business should always have value, and if there were a doomsday scenario for the parent company, the ETN business would be an asset sold to another institution. For argument's sake, I would also suggest that if one of these huge ETN's actually failed, it would be in an environment where every investment anywhere also collapsed.

Sure, you don't want your whole portfolio in an ETN, but wouldn't anyway regardless of the credit risk. It's good that you're reading and aware of this, but mostly inconsequential in the case of DJP. Other ETNs from small issuers with thin trading volumes may be a different story.

The passage you have excerpted is basically just clearing the fact that Barclay's has other investments, separate from this fund, and that their transactions theoretically affect market prices.

[sonarrat]

Lehman Bros. had three ETN's; last I heard the holders were getting 2c on the dollar for them. None of them were very large, but they should still be taken as a cautionary example. Bear Stearns also had ETN's, and if they hadn't been bought out at the last second, they would have been worthless too.

[mtta]

I really agree with being cautious. I look at the size of the issuer and the size of the fund, and I wouldn't buy anything long-term unless it was around $100 Million in assets and backed by a major bank.

That said, I think DJP withstands any kind of scrutiny in regards to credit risk. It holds 1.92 Billion in assets and it is backed by Barclay's.

The failed Lehman ETNs had under 5 Million in assets, which means they were less than one-quarter of one percent of the size of DJP. That's a very big difference.