By Nate Wendler

Exchange-traded funds are the fastest growing segment of the fund market, as investors and advisors alike flock to these products for their low costs, liquidity, and transparency. Riding the ETF wave, though without as much hoopla, are exchange-traded notes, or ETNs, which aren't funds per se but instead are unsecured debt issued by financial firms that pay a total return based upon the performance of a specified index.

As of month-end January, there were 203 ETNs versus 1,189 ETFs.

The ETN structure eliminates tracking error because the issuer bases return on a specified index, not a group of fund holdings, and it provides advantageous tax treatment because all returns are capital gains.

In addition, the ETN structure is often preferred for some products and asset classes with lower liquidity and more complex market structures than plain vanilla debt or equity, such as volatility indexes (VIX) or commodities.

"ETNs are mostly used for exposure to asset classes like commodities or countries which restrict ownership by foreign nationals, and other narrow or esoteric asset classes " says David Hultstrom, president of Financial Architects LLC, a RIA in Woodstock, Ga.

Hultstrom eschews most ETNs but does use one that invests in MLPs, the JPMorgan Alerian MLP Index (AMJ), which eliminates the need for investors to deal with K-1 reporting documents come tax season.

On the cautionary side, buying ETNs-which are essentially a combination of unsecured debt and a total return swap-exposes investors to the credit worthiness and counterparty risk of the issuing bank. This risk is by no means theoretical: Lehman Brothers issued ETNs before its demise during the financial crisis, and investors holding these products saw no return of capital, let alone any return on capital.

Euro Crisis Exposure

The ETN market is currently dominated by European banks, which represent four of the five largest ETN issuers (in descending order): Barclays, JP Morgan, Swedish Export Credit Corp., Deutsche Bank, and Credit Suisse.

Considering the ongoing Greek debt and EU currency crisis, advisors would be remiss in not considering this risk. As Pimco's Mohamed A. El-Erian recently observed, "Greece may also end up including a financial meltdown, a deep output collapse, and social and political turmoil." He questioned whether European political and monetary leadership is capable of solving this crisis and preventing the liquidity problems from turning into solvency crises in other European countries and beyond.

While it is impossible to quantify this counterparty risk, it's a concern that merits consideration. "There are global risks using European banks," says Daniel Roe, a principal at Budros, Rujlin & Roe, a wealth management firm in Columbus, Ohio. "You have real risks with what kinds of assets and loans they are holding, and you also have the perception of higher risk. As we learned in 2008, perception matters and can create runs on banks."

Advisors should also consider the practical consequences of this risk, particularly because concern over these products has led to some insurance underwriters to exclude ETNs from their E&O (Errors & Omission) professional liability insurance.

"The concern we have is the counterparty risk, and we found that our E&O provider [The Cambridge Alliance] would not cover ETNs or structured notes, which introduced business risk as well," notes Matt Reznik, wealth manager at Balasa Dinverno Foltz LLC in Itasca, Ill.

And the specific advantages of the ETN structure also lend themselves to dubious asset allocation decisions. For example, because ETNs are well-suited to illiquid and unusual asset classes, many ETNs are focused on narrow and risky assets. These can play a small but useful role in a portfolio, but for more liquid asset classes the tax advantage of ETNs is probably outweighed by the counterparty risk.

Is there any reason to invest in the RBS Global Big Pharma ETN (DRGS), when three ETFs--SPDR S&P Pharmaceuticals (XPH), PowerShares Dynamic Pharmaceuticals Portfolio (PJP) and Market Vectors Pharmaceutical (PPH) already track this market with lower expense ratios than DRGS (.60% versus .35%, .47%, and .35%, respectively)?

"In the places where ETNs are created, they are not usually asset classes I would be inclined to invest in in the first place," Hulstrom says.

Mitigating Risk

Nevertheless, there are strategies and approaches to help mitigate counterparty risk. Hultstrom recommends looking at the redemption delay in the ETN filing.

Roe suggests watching credit default spreads on the issuer, noting that this was a good warning sign in 2008.

Other advisors take creative approaches to avoiding ETNs altogether. Jerry Miccolis, principal and CIO of Madison, N.J.-based wealth manager Brinton Eaton, has successfully negotiated custom swaps to replicate ETNs. "We use swaps because they don't require putting up capital, and can be structured to pay monthly returns, reducing counterparty risk," he says, adding that the swaps usually cost about as much as the ETN would in annual fees.

For some asset classes, such as commodities and MLPs, ETNs are useful products. And using volatility indexes to hedge tail risk is difficult to do without an ETN. Advisors should carefully consider whether a particular ETN offers exposure not available elsewhere, and should diligently monitor credit ratings and CDS spreads on an ongoing basis. And checking with your E&O provider is crucial.

Taking these steps when evaluating ETNs can help advisors avoid nasty surprises and irate clients should the EU debt crisis escalate into a redux of a 2008-type liquidity event.