Understanding Exchange-Traded Commodities & Notes

In part III of his guide to deciphering exchange-traded products, Morningstar's Gordon Rose explains the basics of exchange-traded commodities, currencies and notes

Gordon Rose, CIIA, CAIA, 7 June, 2011 | 6:58PM
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Read Part I and Part II of this guide to exchange-traded products.

Financial literature is flooded with acronyms many investors struggle to keep up with. It seems as though every new financial product comes with at least two new acronyms. The ETF world is no exception. In fact, already at this point is where we find the first misconception, as we define it Exchange Traded Fund or ETF is not an umbrella term but rather a specific product-type within a wider range.

In part II of this guide, I discussed exchange-traded funds (ETFs), which represent about 90% of the overall exchange-traded product (ETP) market in terms of total assets under management. Here, I will provide a more detailed analysis of the key aspects of exchange-traded notes (ETNs) and exchange-traded commodities and currencies (ETCs).

Globally, ETCs and ETNs represent just a fraction of the overall ETP market in terms of total assets under management. According to data from Blackrock, ETCs and ETNs had combined assets of $183.7 billion at the end of Q1 2011, compared to $1,399.4 billion in ETFs. According to ETF Securities, $173 billion was invested globally in ETCs at the end of March 2011, leaving about $10 billion in AUM for ETNs. The picture in Europe is similar to the global snapshot. ETCs and ETNs account for $33.4 billion in AUM compared to $307.5 billion for ETFs.

Exchange-traded Notes (ETNs)
Before getting into the details of ETNs I would first like to highlight a misconception that persists within the investment community. ETNs can be collateralised investments. In fact, most providers do collateralise their ETNs.

As mentioned in part II of this guide, ETNs are not UCITS compliant but they are UCITS eligible. This allows ETNs to offer exposure ETFs are not permitted to offer under UCITS rules, e.g. single commodity exposure. ETNs typically offer exposure to commodities, currencies, volatility indices, strategy indices, and carbon emissions benchmarks whereas ETFs focus predominately on equity and fixed income exposures.

Generally, ETNs are senior, unsubordinated debt instruments issued by a single bank and listed on the exchange. The underwriting bank agrees to pay the return of a reference benchmark, minus fees. Therefore in purchasing these products, investors assume direct exposure to the credit risk of the underwriter--in the case of uncollateralised ETNs. Meaning, one factor that can affect the value of an ETN is the credit rating of the issuing bank. However, there is a long list of factors influencing the price of a note as they can be structured in many different, sometimes very creative, ways. As the purpose of this article is not so much to cover the specifics of price discovery of ETNs, I will not delve into further detail as this would be a topic on its own but we strongly recommend that investors make sure they fully understand the note they invest in.

Collateralised ETN
As is the case with swap-based ETFs, ETNs are generally collateralised. Typically, government bonds and/or blue chip stocks are pledged in a ring-fenced account with a third party as collateral. The level of collateralisation is at the discretion of the issuing bank and can therefore range from 1% - 100%+. Royal Bank of Scotland, db ETC, ETF Securities and Source all offer collateralised ETNs and/or ETCs.

Uncollateralised ETNs
As mentioned previously, uncollateralised ETNs are fully exposed to the balance sheet risk of the issuing bank. In the event of a sponsor’s default investors can lose all or most of their investment. After triple-A rated Lehman Brothers collapsed; their ETNs were de-listed from the New York Stock Exchange and left some investors high and dry. According to Morningstar research, ETNs backed by Lehman Brothers had about $15 million in total assets under management at the time of de-listing as they had only been marketed for less than a year. We suspect that the vast majority of this $15 million was seed capital and the remaining investors had to stand in line as unsecured creditors with a chance to recover only a fraction of their initial investment. iPath and Societe General offer uncollateralised ETNs.

Structure of ETNs
An ETN’s issuing bank agrees to pay the return of a reference benchmark, less fees. How do banks deliver on these promises? A straightforward answer would be: “hedging”. There are two primary ways that banks hedge their exposure. Let’s take a simple example of a note that returns the performance of the EURO STOXX 50 Index. In order to hedge its exposure the bank would typically use futures or forwards or simply buy the index’s constituents to make sure they can deliver the return on the reference index at maturity. For more complex strategies or when facing less liquid futures or forwards markets, the issuer can make use of complex option strategies in order to hedge their exposure. This obviously is a more complex and costly procedure and has additional risks attached to it. In particular, options have non-linear payoffs which may result in hedging errors. However, the focus of this article is ETNs rather than the full mechanism behind the hedging procedure; hence I will not delve further into this topic. My intention is rather to highlight some possible risk factors investors should be aware of when deciding whether an ETN is a suitable vehicle for their purposes.

Another simple way to hedge the exposure of the ETN would be to enter into an off-setting contract with another bank and let them worry about the hedging. But from an investor’s point of view, this strategy could be less favourable as it introduces additional counterparty risk.

Advantages of ETNs
ETNs can offer exposures which are not permitted within an ETF structure, as mentioned previously. iPath, for instance, offers ETNs returning the performance of the VSTOXX Futures indices. Those indices provide exposure to European equity volatility through rolling VSTOXX futures strategies. As the index offers exposure strictly to futures contracts following the implied volatility of equities, the ETN does not comply with UCITS regulations and a similar exposure therefore would not be permitted in an ETF wrapper.

Furthermore, ETNs usually offer superior tracking relative to ETFs as they reflect a simple promise on the part of the sponsor to return the performance of their benchmark (minus fees) at maturity. Investors interested in a more detailed treatment of tracking error are advised to read an article we published on the topic last year.

Disadvantages of ETNs
As ETNs are debt securities they expose their owners directly to the balance sheet risk of the issuing bank. Nevertheless, in the post-Lehman period many issuers have started to collateralise these notes; thereby reducing counterparty risk. Ultimately however, the level of counterparty exposure within collateralised ETNs is at the discretion of the issuing bank, as mentioned previously.

Furthermore, as ETNs account for only a small portion of the overall ETP market, they are far less liquid than most ETFs (as measured by secondary market on exchange trading volumes).

Exchange Traded Commodities/Currencies
In essence, exchange-traded commodities are simply an ETN that tracks either individual commodities or broader based commodity indices. Both are debt securities that tend to be issued off balance sheets of the issuing entity rather than as a special purpose vehicle. Furthermore, both are not UCITS compliant. They do not meet diversification rules under UCITS regulations. Again, this opens the opportunity to offer exposure ETFs cannot offer. But more importantly, the permissible counterparty exposure is left to the discretion of the provider and can therefore be negative, or as high as 100%. As such, the term ETC is as much a marketing tool as anything else and is used to highlight the fact that ETCs track commodities/currencies.

ETCs can be physically backed by the underlying commodity (currently only the case for precious metals and a handful of industrial metals) or may track futures-following indices in order to achieve their objectives. These products are not UCITS compliant, but as is the case with ETNs, are UCITS eligible.

ETCs can be collateralised in the same way that ETNs can, as mentioned previously.

For a detailed explanation about investing in commodities via ETPs, readers are referred to an article we published earlier on this topic: “Be Cautious with Commodities”.

Like exchange traded commodities, exchange traded currencies are also secured debt securities. They give exposure to foreign exchange rates and are also not UCITS compliant but rather UCITS eligible. Exchange traded currencies offer exposure to foreign exchange movements by tracking indices on currency pairs. ETF Securities, the largest provider of such products, offers a massive suite of ETCs tracking currency pairs and also has a number of leveraged options available.

It is important to understand the different structures that exist under the broader ETP umbrella. More specifically, it is vital to comprehend the risks associated with each of them, the ways in which providers have structured these products to minimise the associated risks, and the compensation that investors receive in exchange for assuming these risks (better tracking, lower fees, etc.). Investors should first select their desired exposure and then choose the most suitable vehicle to reflect their view and risk profile.

We hope that this series of articles helped you to better understand the world of exchange traded products and will assist you in making a well informed investment decision.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Gordon Rose, CIIA, CAIA,

Gordon Rose, CIIA, CAIA,  is an ETF analyst with Morningstar Europe.

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