The already tarnished reputation of exchange-traded notes has taken another hit in recent days, but reports of the structure’s impending demise may prove far from the truth.
The latest debacle saw Barclays abruptly suspend the creation of new units of two of its most popular ETNs, VXX and OIL, which offer exposure to the Vix volatility gauge and crude oil prices.
It emerged that Barclays – the second-largest player in the ETN market, according to Morningstar data – had only obtained regulatory approval to offer $20.8 billion worth of structured notes, including ETNs, but that it exceeded it by $15.2 billion. It will now have to buy back the excess at the original purchase price, incurring a loss of $450 million.
This was not the first explosion in the ETN world. Two years ago, Credit Suisse, then the largest sponsor of ETNs, delisted and suspended nine leveraged and inverse ETNs from major exchanges.
This came two years after the Swiss bank’s short XIV ETN volatility was killed after crashing 90% in one day.
In March 2020, WisdomTree had to close its three leveraged oil products after their value was wiped out by Covid-induced market volatility.
“ETNs have been dying a long, slow and painful death for years. Whether this most recent blot on a completely smeared balance sheet for this wrapper is its last breath or not, honestly, I don’t know,” Ben said. Johnson, director of global ETF research at Morningstar.
Will Rhind, managing director of GraniteShares, which offers a range of exchange-traded products, said the ETN market hasn’t really recovered after being “shattered” by the global financial crisis.
“The ETN market is essentially dead, except for limited instances where people have offered highly tradable products, such as three times long or three times short, or volatility,” Rhind said.
ETNs are IOUs issued by a sponsor, which promises to provide the returns of an index in exchange for a fee. This sponsor must be a bank in the United States, but not in Europe, where Guaranteed Special Purpose Vehicles may offer ETNs
They are often lumped together in the booming $10 billion exchange-traded fund industry. Although not technically ETFs, they both fall under the category of exchange-traded products.
ETNs suffer the disadvantages of all structured products. They are exposed to counterparty risk in the event of issuer default, they have an alarming tendency to explode in times of market stress, they often use leverage and options — amplifying gains and losses — and issuers can withdraw them without notice, increasing investors’ investment risk.
For Johnson, at least, they also tended to be terrible investments. In the United States, ETNs have seen net inflows of $25.9 billion since their debut in 2006, according to Morningstar, but current assets stand at $13.4 billion.
Given that they don’t pay dividends or coupons, this suggests that 48% of the money that has ever been invested in US ETNs has gone “poof!” in Johnson’s words.
These losses can largely be due to the leveraged and inverse nature of many ETNs. The laws of arithmetic dictate that the longer they are held, the more likely they are to be in deficit.
“An investor can make a specific return under specific conditions, but what we’ve seen historically is that those conditions almost always benefit the issuer,” Johnson added.
“The house almost always wins. [The Barclays episode] is a rare example of losing the house, because someone at the door forgot what they were doing and gave away too many chips.
Johnson also argued that ETNs are more dangerous than similar structured products placed with institutional buyers because they are publicly traded.
“It releases the ETN zoo into the wild. It’s a format that has made these things free-roaming animals and more than one investor has been mauled by an ETN tiger.
Morningstar data puts total ETN assets worldwide at $32.9 billion at the end of February. Although the structure has missed out on the rapid growth of ETFs in recent years, it has proven resilient, with assets under management barely below the high of $35.7 billion in January 2018.
Growth is also evident if one takes a broader view of what exactly qualifies as an ETN. ETFGI, a consultancy that uses a definition that includes many gold ETPs, values global assets under management at $125 billion, an increase from previous years.
Deborah Fuhr, founder of ETFGI, believed that the relevance of ETNs was declining to some extent, but “as with everything, investors need to understand what they are buying”.
“A rating doesn’t have the diversification or other requirements of a mutual fund or an ETF,” Fuhr said. “If you want exposure to something that doesn’t fit in an ETF package, that tells you it’s riskier than an ETF. This is buyer beware. Do your homework.”
Peter Sleep, senior portfolio manager at 7 Investment Management, said ETNs “serve a purpose” and that 7IM has used them, albeit only ETNs suited to its needs.
Sleep said ETNs were very complicated “which means the pricing is murky”, but that banks like them because they provide cheap funding and are “very profitable as they often involve a lot of transactions , which pushes profitable flows through the banks’ dark pools”.
“This is confirmed by the fact that if I meet with an investment banker to discuss a bespoke ETN, I am treated as if I am the wittiest fund manager in the UK and have lunch in the restaurant. the fanciest. This can only happen because there is such high profit for someone other than my clients,” Sleep added.
“I don’t think a clerical error at Barclays is going to end the sauce.”
Additional reporting by Chris Flood
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