Exchange-traded notes, unlike their more popular cousins, exchange-traded funds, expose investors to the credit risk of the issuer.

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Exchange-traded notes, unlike their more popular cousins, exchange-traded funds, expose investors to the credit risk of the issuer. This came to light last week when an ETN fell well below its net asset value, says Bradley Kay, Morningstar analyst.

“If the [ETN] issuer goes bankrupt, you are out of luck — just another creditor in line,” Kay says. ETF investors, by contrast, could lay claim to the underlying securities, he says.

Investors in three Lehman Brothers ETNs likely managed to sell before the investment bank filed for bankruptcy protection, Kay says. The funds had low trading volume and fell to $14.5 million in assets at the end of August, probably representing Lehman’s startup capital, compared with $15.6 million in February, he says.

The funds never took off, partly because of worries about Lehman and because they were similar to established ETNs, Kay adds.

But a Morgan Stanley-backed ETN, MarketVectors Renminbi/USD (CNY), better illustrates the potential risks. Investors grew concerned about Morgan Stanley’s debt last week, and on Sept. 16, shares of the ETN, which mimics the S&P Chinese Renminbi Total Return Index, dropped 7.8 percent below the net asset value of the portfolio, to $36.92. The drop reflected concerns about Morgan Stanley, not the value of the Chinese currency, Kay says.

Investor concerns are normal in times like this, says Noel Archard, head of ETF and ETN product development for Barclays, a big issuer of ETNs and ETFs. “People are just evaluating the situation,” he says.

Generally, Kay prefers ETFs to ETNs, which have been around only for about two years. While most ETN issuers have strong credit, the notes still expose investors to issuer risk.