In the wake of the Silicon Valley Bank collapse, and with some banks still in peril, exchange-traded notes, debt instruments that are backed by the financial strength of their issuing banks, are facing a precarious future.
Take the X-Links notes, sponsored by Credit Suisse. The bank is involved in a corporate takeover by a larger rival (UBS) that could spell the end of its ETN lineup, which includes the Credit Suisse X-Links Crude Oil Shares Covered Call ETN (USOI), the Credit Suisse X-Links Gold Shares Covered Call ETN (GLDI) and the Credit Suisse X-Links Silver Shares Covered Call ETN (SLVO).
The firm announced its regular monthly coupon payments for these funds on April 3, so on the surface things seem normal. But Credit Suisse’s ETNs have an underlying history of trouble. Back in 2020, nine of the firm’s ETNs were delisted. Among this group were its “VelocityShares,” linked to the S&P 500 VIX index. One note that bet against volatility, the VelocityShares Daily Inverse VIX Short Term ETN, was overwhelmed by extreme market turbulence in 2018. After that, the liquidation of this and other volatility ETNs wasn’t a surprise.
A 23-Year History
Currently, there are 82 ETNs with $8.2 billion in assets, according to the ETFAction.com database. Most of these assets are invested in niche areas tied to commodities, volatility and leveraged or inverse strategies.
The largest ETN by assets is the JPMorgan Chase Alerian MLP ETN (AMJ), which has $324 million. Over the past month, the note has experienced average daily volume of 396,644.
The first ETN to surface in global markets was in 2000. The original note was sponsored by Bank Leumi in Israel and was linked to the Tali 25 index, a benchmark of 25 leading companies in Israel.
Since then, ETNs have been lauded and promoted by the banking industry for their tax-efficiency. Because the bank issuer is paying for the full value of the index, there is zero tracking error. But that all depends on the strength of the banks. Is the added dimension of credit risk worth it?
Even before the latest bank turbulence, ETNs had a sketchy history going back to the Great Financial Crisis.
In 2008, the Lehman Brothers Opta ETNs went bust. At the time, competing ETN sponsors like Barclays Bank had the chance to step in to save Lehman’s ETN shareholders, but they didn’t. Instead of creating confidence in the ETN marketplace, this spurred doubt. And today, those doubts are still rightfully lingering. What should advisors do?
Find An ETF Instead
ETNs “provide a useful wrapper for hard-to-track areas. But the credit risk of the counterparty remains a relevant risk,” says Mike Akins, the CEO at ETFAction.com. For this reason, locating an ETF equivalent for the same target asset class is likely to be the safer strategy.
Using the ETF structure immediately eliminates the risk that the product will go bust because of bank failure. And while ETNs might be slightly more tax-efficient than traditional ETF, those benefits would be negligible if the investment were kept inside a tax-friendly retirement account anyway.
Also, using ETNs inside a portfolio complicates the investor’s asset allocation. For example, a portfolio model is likely to misclassify a commodity-linked note as exposure to commodities. In reality, the investor doesn’t have exposure to commodities but rather to the unsecured debt of the ETN issuer.
Advisors who insist on using ETNs with client portfolios should tread with caution. Akins adds, “ETNs require a higher level of due diligence and ongoing monitoring.”