One of the most recognizable names in the U.S. exchange-traded products business—Deutsche Bank—is in acute financial distress.
Last week, the German bank had its long-term credit rating downgraded by S&P Global Ratings by one level to BBB+. Last year, Deutsche Bank’s U.S. operations were designated to be in “troubled condition,” according to a report from the U.S. Federal Reserve.
While both of these very harsh strikes are likely to increase the bank’s cost of doing business, they cast a dark shadow on Deutsche’s exchange-traded notes.
ETNs are unsecured debt instruments issued and underwritten by a bank or other large financial institutions. As with traditional debt securities like bonds, ETNs come equipped with maturity dates and a promise from the issuer to pay investors. ETNs track a variety of asset classes and indexes, including benchmarks linked to stocks, bonds, currencies and commodities.
Unlike exchange-traded funds, ETNs carry credit risk and the possibility of loss if the issuer becomes insolvent or goes bust.
The 2008 collapse of Lehman Brothers resulted in the blowup of three notes: the Opta Lehman Commodity Pure Beta ETN (RAW), Opta Lehman Commodity Pure Beta Agriculture ETN (EOH) and Opta S&P Listed Private Equity ETN (PPE). While the losses were relatively contained (approximately $14.5 million was invested in Lehman’s ETNs just ahead of its bankruptcy), the current problems at Deutsche Bank are a stark reminder of the imminent danger ETN investors face when issuers get into financial trouble.
With almost $400 million invested in the DB Agriculture Short ETN (ADZ) and $106 million in the DB Gold Double Long ETN (DGP), these are among the firm's largest ETN products by assets. The firm’s other ETNs are leveraged or inverse trading instruments linked to broad commodity indexes, along with crude oil and base metals. This latter group has a total of less than $50 million in assets.
ETN proponents tout the product’s zero tracking error. How does this work? ETN issuers promise to give shareholders a performance return that is identical to the underlying benchmark, minus fees. As a result, ETNs don’t suffer from a discrepancy between a product’s actual return and its underlying index return. This discrepancy is known as “tracking error” and is quite common with both index mutual funds and ETFs.
Financial advisors must determine for their clients whether the benefits of zero tracking error by ETNs is worth absorbing the credit risk inherent in these products. In most cases, the risks aren’t justified because there are plenty of ETN alternatives to choose from with similar investing strategies—such as those housed in an ETF-like wrapper. Instead of trading oil-focused ETNs, a tactical investor could eliminate ETN credit risk by simply choosing the United States Oil Fund (USO) or its bearish cousin, the United States Short Oil Fund (DNO).
Advisors who choose to use ETNs inside client portfolios should avoid the common mistake of classifying them as commodities, currencies or whatever underlying assets the products are proposing to track. In reality, investing in ETNs increases a person’s fixed-income exposure with all the financial risk concentrated in a single issuer.