A New Threat to Trendy Investors

Millions of investors now rely on exchange-traded funds and notes as an integral part of their investing strategy. Many of them knew of the risks some of these investments contained. But the recent Lehman bankruptcy has raised concerns about one such vehicle's continued survival.

Exchange-traded notes (ETNs) came relatively late to the party in 2006, while ETFs like the SPDR Trust (AMEX:SPY) have been around since 1993. Recently, though, ETNs have gained some popularity, with ETF giant Barclays (NYSE:BCS), Invesco's (NYSE:IVZ) PowerShares unit, and HSBC (NYSE:HBC) all ramping up their ETN offerings.

The crucial difference
At first glance, ETNs seem identical to ETFs. Unlike traditional mutual funds, shares of ETNs and ETFs are available on major stock exchanges through your brokerage account. ETNs and ETFs both share the advantage of being tradable throughout the day. Both generally pin their values to the movements of indexes tied to certain types of investments, ranging from stocks and market sectors to commodities and other financial measures.

But while they may look similar on the outside, ETNs and ETFs are very different on the inside. ETFs, like most mutual funds, directly hold assets related to their investment objective. For instance, a sector ETF will typically own shares of the companies in a particular industry. Even an ETF that invests outside the stock market holds an actual asset, such as a futures contract, that is tied to its value and intended performance characteristics.

ETNs, on the other hand, are technically debts of the company that issues them. That structure gives them some potential tax advantages that ETFs lack. Yet although their performance is contractually tied to whatever index they're intended to track, ETNs don't have any assets, other than a claim against their issuer for payment according to the terms of the contract.

When counterparties can't pay
That's where the problem arises. When Lehman Brothers declared bankruptcy, the fate of its three ETNs was left in limbo. Whereas ETF holders would be able to liquidate actual assets if the ETF issuer went bankrupt, ETNs have nothing to liquidate. So while Lehman's Private Equity ETN tracked shares of American Capital (NASDAQ:ACAS), Blackstone (NYSE:BX), and Fortress Investment Group (NYSE:FIG), shareholders can't count on an ETN's value continuing to track that index; for Lehman's ETNs, shareholders were left only with an unsecured bankruptcy claim.

The problem isn't a huge one in Lehman's case -- the Lehman Private Equity ETN only adds up to roughly $4 million in assets, and the other two Lehman ETNs are similar in size. But the overall ETN industry is much larger, with assets of more than $6 billion as of earlier this year.

Source: Morningstar, Yahoo Finance.
* Return from Oct. 19, 2007 inception. 
** Return from Feb. 28, 2008 inception.

There's no immediate reason to believe that other major ETN issuers are destined to follow in Lehman's footsteps. Both Barclays and Deutsche Bank, which issues the PowerShares ETNs, recently earned solid AA ratings from Standard & Poor's. Yet with billions potentially at stake, investors are understandably concerned.

Advice for exchange-traded note investors
If you're not already invested in ETNs, you may want to wait until financial companies gain a bit more stability before jumping on the bandwagon. Because many ETNs cover areas for which there's already a comparable ETF with similar exposure, there's no immediate need to take the issuer risk involved with ETNs.

On the other hand, if you already own ETNs, check on the financial health of the issuer. Although there may be tax consequences, you again may want to switch to a comparable ETF if you're concerned about what could happen to the issuing company.

More on tackling threats to your money:

• How to avoid the mistake that could cost you a fortune.
• Stock prices that are too good to resist.
• A beginner's guide to making millions.