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Introduction to Exchange-Traded Notes

Introduction to Exchange-Traded Notes
March 23
19:40 2012

We recently discussed the VXX, which tracks the Volatility Index (VIX). The VXX is an exchange-traded note (ETN), and since the ETN is a relatively new financial product, first introduced in 2006, it is worth an examination.

The ETN is similar in many respects to the exchange-traded fund (ETF) and is traded in much the same manner. The first ETNs were issued by Barclays Bank, which treats them as senior debt (that is, the holders would have a priority claim in the event of a bankruptcy—not that this usually means much). Barclays’s first three were all commodity-based, tracking oil, the Goldman Sachs Commodities Index, and the Dow Jones-UBS Commodity Index. The VXX dates to February 3, 2009.

Subsequently other ETN issuers jumped into the game. As of February 2012, 1,189 ETFs were listed in the U.S. compared to 203 ETNs, and ETFs had $1.134 trillion in assets under management compared to $15.5 billion for ETNs. Clearly the ETN has a long way to go to equal the ETF’s popularity.

While an ETF typically represents an actual stake in the underlying investment—that is, an equity ETF will hold stocks; a commodity ETF will hold commodity futures contracts—held in trust, an ETN is a structured note: a derivative married with what is in essence a bond. For that reason, the main consideration with ETNs is the credit risk associated with the issuer. With an iPath (Barclays) ETN that risk is minimal, as Barclays is some three centuries old, possesses about $1.5 trillion worth of assets, and holds an A+ credit rating from Standard & Poor’s—better than some sovereign countries. However, as ETNs have become more widespread, credit risk has become more of an issue, so if you choose to trade in these instruments, make it a habit to research who is backing the note.

You should also be aware that credit risk becomes more of a threat when markets are in turmoil. During the 2008 financial crisis, the Opta ETN series was delisted when its issuer, Lehman Brothers, collapsed, so there is a very real if still small risk that an entire ETN investment can be lost. What carries far more practical significance is the fact that this credit risk can affect ETN value if the solvency of the issuer comes into question, sending prices plummeting even if no bankruptcy actually occurs. This, too, happened during the worst of the financial crisis.

Another important issue is that ETNs carry an annual expense, usually in the range of 75 to 100 basis points. (The current expense for VXX is 0.89%.) They are often structured specifically for short-term or at most medium-term investing—for example, in the case of VXX as a hedge against market declines or to speculate on short-term market movements.

The major advantage of ETNs over ETFs is the absence of tracking error. ETFs suffer tracking errors (deviation from the performance of the index they are designed to track) for a variety of reasons. One is the handling of dividends; ETFs accumulate them and pay them out quarterly, which means a small portion of the ETF is tied up in cash rather than securities. It’s also generally not possible to reinvest ETF dividends, mostly because it is not possible to buy fractional shares of an ETF as it is with a mutual fund.

ETNs, on the other hand, are derivative instruments specifically designed to directly track their underlying index. That means tracking error is eliminated.

The main debates over the relative merits of ETFs and ETNs focus on tracking error versus credit risk; the tax treatment of ETNs is also touted as more favorable, though that can vary easily from country to country depending on local tax laws and in the U.S. as well as the IRS updates its regulatory decisions regarding ETNs. From our perspective, the main value of the ETN is to open up new investment vistas that are not accessible any other way—the ability to hedge against or speculate on market volatility through the VXX ETN being a primary example.

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