S&P Indices webinar: Experts explain pros and cons of ETNs versus ETFs

By Emma Trincal

New York, June 15 - Exchange-traded notes have become very popular among investors for their low cost, liquidity, tax efficiency and ability to give access to complex strategies. Still, investors are not always as familiar with these vehicles as they are with exchange-traded funds.

A 2012 structured products webinar organized by S&P Indices Tuesday called "Roadmap for Accessing Alternatives and Other Classes via ETNs" aimed to explain to the 300 participants - mostly investors and financial advisers - the fundamental differences between those two vehicles.

The U.S. ETN market represents $16 billion in outstanding asset volume, said Bernd Henseler, vice-president of structured products at Standard & Poor's, citing data from Bloomberg.

Two hundred and 14 ETNs are listed on NYSE Arca and the average daily trading volume is over $80 million, according to Bloomberg data.

Debt

ETNs were defined as debt obligation subjecting the investor to the issuer's credit risk in return for a strategy that pays the return of the index without tracking error.

The key word is "credit risk", the panelists said.

"A common mistake we see among investors when it comes to ETNs: people don't understand the structure," said Christian Wagner, chief executive and chief investment officer at Longview Capital Management LLC. "Make sure you understand how these things are issued. They are debt securities.

"Some people exaggerate the potential for defaults but nevertheless, you are subject to the issuer's credit risk. One of the best ways to analyze it is through the CDS of the issuer. Treat this security as any other bond. Understand the ratings of the issuer, the metrics. Is it trading at a discount or at a premium? Using a standard fixed-income approach is very helpful.

Incurring the issuer's credit risk is not a concern for ETF investors who own interests in the underlying securities.

"An ETF is a pool of underlying assets that investors have rights to. It's fundamentally different from an ETN, which is a simple contractual obligation to pay you based on a certain formula," said Courtenay Myers Lima, partner at Latham & Watkins LLP and one of the speakers.

"There may be a lot of reasons why you would choose an ETN versus an ETF. ETNs enable you to access products more efficiently or with different tax consequences or to focus on a more specific strategy than an ETF would," she said.

But investors need to always keep in mind what really sets them apart from ETF is credit risk, she said.

Taxes, tracking errors

Panelists said that ETNs may offer potential tax efficiencies, which vary from one product to another. But they recommended that investors read the details of the tax treatment as stated in the prospectus and that they seek the advice of tax experts.

"As index-based investments, ETNs have attributes that could provide more tax-managed returns," said Keith Styrcula, chairman of the Structured Products Association, who moderated the panel.

For instance, some market sources explained, Master Limited Partnership ETNs do not incur double taxation. Also, commodity ETNs are more tax efficient than their ETF counterparts as they don't generate a K1 but rather a 1099.

Another important advantage of ETNs is that they are less subject to tracking errors than ETFs.

"ETNs are able to deliver access to strategies without any potential index-to-NAV tracking error as an ETN is an obligation of the issuer," said Thomas Haines, head of listed products at RBS Global Banking & Markets. "ETFs are fund structures that replicate an index."

A gate to alpha

Another key advantage of ETNs is to give investors access.

"ETNs are the preferred vehicle for getting exposure to certain markets or asset classes that are hard to access," said Christopher Yeagley, who runs the ETN business at UBS.

The range of asset classes is wide, including equities, commodities, currencies, fixed-income, futures, multi-assets or "any combination of asset classes put together in a strategy that reflects your view," said Myers Lima.

The strategies can be sophisticated as ETNs can use systematic rules for going in and out of the market, which may not be as cost-efficient with a fund, an industry source said.

Some ETNs, for instance, give access to hedge fund-replication, long/short, trend-following, and volatility underlying strategies that are not easily tracked by an ETF.

"ETNs offer the ability to combine a variety of asset classes as well as strategies that can't really be done in a cost-efficient way with a buy-and-hold ETF. At RBS, for instance we offer trend-following strategies through our TrendPilot ETNs," said Haines.

"ETNs that are relevant are those that give access to markets where an ETF doesn't work well," said Yeagley.

Commodities and MLP equities are the top asset classes, according to Bloomberg with 36.1% and 28.6% of the outstanding volume. Volatility-based ETNs represent 25.1% of the total. Equities make up 6.1% while fixed-income represent 2.8%. Currencies and real estate are the laggards with 1.3% and 0.1% respectively of the total outstanding.

"ETNs offer a convenient wrapper for certain areas that would normally difficult to access," said Longview Capital's Wagner.

"We see a lot of interest in the fixed-income or income space, for instance steepeners, flatteners and MLPs."

Trading tool

ETNs may offer efficient trading tools when used properly, the panelists said.

"We use ETNs in many strategies, particularly when expressing our views regarding volatility and commodities," said Wagner.

"In the volatility marketplace, we invest in various ways comprising long/short, leveraged and dynamic strategies.

"We use volatility products for hedging purposes. We also do cross-asset hedging.

"ETNs can also be shorted, but you have to be careful with asset classes that are very thinly traded. The borrow cost may be excessive," he said.

Market sources said that differences exist in terms of cost and reset between leveraged ETNs and leveraged ETFs. Unlike ETFs, many ETNs don't have a daily reset, which can be an advantage in certain conditions, especially for inverse products in highly volatile markets.

Redemption

Liquidity is a benefit common to both ETFs and ETNs. But the daily redemption feature is different between the two vehicles, said RBS' Haines.

Myers Lima explained that the investment may either be redeemed through a broker via an exchange or put back to the issuer.

"On the exchange, you incur the bid/ask spread but you benefit from immediate liquidity. You get the immediate price," she said.

"When you put it back to the issuer you're getting the NAV, but it is typically determined the day following your decision. The advantage is that you're not subject to the bid/ask spread."

However, she said that in order to redeem directly from the issuer, an investor must meet a minimum size requirement, which can be $1 million or more.

"This repurchase feature in theory is available to anybody but may more often in practice be used by institutional players. With ETFs, it's only available to authorized participants," she said.

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