About the Editor
Ben Johnson, CFA, is director of global ETF research for Morningstar. Before assuming his current role in 2012, he was director of ETF research for Europe and Asia. He also previously served as a senior equity analyst, covering the agriculture and chemicals industries. Before joining Morningstar in 2006, he worked as a financial advisor for Morgan Stanley.

Johnson holds a bachelor's degree in economics from the University of Wisconsin. He also holds the Chartered Financial Analyst® designation. In 2015, Fund Directions and Fund Action named Johnson among the 2015 Rising Stars of Mutual Funds.

Investment Strategy
Morningstar ETFInvestor scans the globe for value and improving fundamentals across virtually all asset classes. Editor Ben Johnson draws upon academic and practitioner research — including Morningstar's sizeable bench of stock, bond and fund analysts — to find reliable drivers of outperformance.

Morningstar ETFInvestor features two real-money portfolios.

The ETF Income Portfolio assembles a high-quality collection of income-generating ETFs with the goal of earning 5% in excess of the 30-day T-bill rate over a full business cycle. The portfolio adheres to a benchmark-agnostic strategy in its search for absolute returns.

The ETF Global Asset Allocation Portfolio, on the other hand, is more benchmark sensitive. It seeks undervalued asset classes with improving fundamentals. The strategy seeks to beat the 60/40 MSCI ACWI/Barclays US Aggregate benchmark over a full business cycle, with the least risk possible.

Feb 06, 2016
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Ben Johnson, CFA,
Director, Global ETF Research and Editor
Ben Johnson, CFA, is director of global ETF research for Morningstar. Before assuming his current role in 2012, he was director of ETF research for Europe and Asia. He also previously served
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ETFInvestor Weekly Update - January 24, 2016

Reminder: Notes are Not Funds

Every so often investors have been served with a not-so-gentle reminder of the perils of investing in exchange-traded notes, or ETNs. The week of January 18 served us with two such nudges.

First, on January 20, UBS UBS announced that it would redeem a pair of its ETNs, ETRACS 2x Monthly Leveraged S&P MLP Index ETN MLPV and ETRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure ETN MLPL. Both notes have cratered in recent weeks, triggering what in the language of their prospectuses is an “acceleration event” that will ultimately result in their redemption. In layman’s terms, this means that this bet has moved so hard and so fast against UBS that it’s been forced to call it off.

On that same day we saw an enormous premium develop in the shares of another ETN. As of the close of trading on Wednesday, January 20, iPath S&P GSCI Crude Oil ETN OIL was priced at $5.51 per share. Its net asset value at day’s end was $3.70 per share. This meant that the ETN’s shares were trading at a nearly 49% premium to their actual worth. By the time the closing bell rang on Friday, January 22, OIL’s shares were priced at $4.83 and its indicative net asset value (a real-time estimate of its worth, not an official value) was $4.49. Over the course of two days the premium withered to a still-troublesome 7.6%. As demand for OIL’s shares has surged (its total shares outstanding have increased 32% since mid-November 2015) Barclays, the note’s sponsor hasn’t released a sufficient number of new ones from inventory to adequately supply the market. The result has been a persistent premium for OIL’s shares that first materialized late last year only to mushroom and subsequently implode this week.

ETNs are often grouped together with exchange-traded funds, or ETFs, in casual conversation, but these seemingly close cousins are in reality very distant relatives. Notes are not funds.

Notes are born out of the structured products desks of investment banks. Bets that had historically been offered in illiquid and difficult-to-access formats are now available in an ETN wrapper to anyone who can plug into the stock exchange.

Notes do offer some benefits. First, they are far more liquid than traditional structured products. Secondly, because they are unsecured debt obligations, they receive more favorable tax treatment relative to ETFs that invest in corners of the market like commodities and MLPs. Third, well, there is no third.

Banks aren’t writing these IOU’s out of the goodness of their hearts. Notes give banks access to funds--investors are loaning them money--without having to put up any collateral. Investors are taking on credit risk by investing in an unsecured debt obligation of the issuing bank. Also, most note issuers are collecting big fees. The median expense ratio amongst the 197 ETNs in Morningstar’s database is 0.75%. Furthermore, investors should be aware that some ETNs of older vintages, including OIL, charge path-dependent fees. This means that their rake may actually go up even has their share prices plummet, thus adding insult to injury. Banks are betting on their terms. As the case of the redemption of the UBS notes shows, banks may opt out if these bets move against them. And as the throttling down of the issuance of new shares of OIL shows, banks can also slow the pace of betting (and often reserve the right to halt it temporarily) at the expense of any poor souls that naively buy shares of these notes at prices far in excess of their true value.

One thing is clear when it comes to ETNs: the house always wins.



Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.



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