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, $173bn was invested globally in ETCs at the end of March 2011, leaving about $10bn in AUM for ETNs. The picture in Europe is similar to the global snapshot. ETCs and ETNs account for $33.4bn in AUM compared to $307.5bn 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 $15m 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
$15m 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.
Conclusion
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.
Gordon Rose, CIIA, is an European ETF Analyst with Morningstar.
