Exchange-traded notes (ETNs), the latest product innovation to hit the Canadian market, share many features with exchange-traded funds (ETFs). But there are a few significant differences that advisors should note, said Tim Edwards, vice president of investor solutions, Barclays Bank PLC., in a speech at the 2012 Exchange Traded Forum in Toronto Thursday.
The essential difference is that with ETNs, the financial stability of the issuing company that will eventually be redeeming the notes is of paramount importance. With ETFs, there is no redemption date. Also, other characteristics, such as liquidity of the underlying securities and tracking error, are of more significance with ETFs, said Edwards.
Earlier this month, Barclays launched three new ETNs under the iPath brand, giving investors access to the returns offered by three U.S. indices, translated into Canadian dollars. Two of the new iPath Canadian-traded notes are linked to U.S.-based S&P 500 volatility indices and one is linked to crude oil prices. Until the launch of the Barclays’ notes, Canadians had access to ETNs only through cross-listed products developed in other markets.
Like ETFs, ETNs tie their returns to an underlying index, but they are structured as senior debt notes and are typically issued and guaranteed by a major bank, such as Barclays. The returns of ETNs are based on the performance of the underlying index during a defined period until the redemption date, minus annual management fees. They promise a return that tracks the index but unlike ETFs do not trade portfolios daily to match the index, and therefore their returns are not affected by transaction costs or liquidity problems in matching the benchmark index portfolio.
“There is no underlying portfolio of assets that replicate a benchmark,” said Edwards. “What you own is a promise from the issuer to pay a return at maturity, minus the fees.”
Notes are somewhat similar to bonds in that they are a promise to pay out at maturity, usually within 10 to 30 years, but many have features that allow for early redemption at certain times. ETNs trade like a stock on public exchanges, and can also be sold short like a stock. Although ETNs are new to Canada, the market for ETNs in the U.S. is about five years old and totals US$17 billion, a small fraction of the total ETF market of US$1.7 billion.
Edwards said the bulk of ETN assets are in notes tied to managed futures or indices that are tied to market volatility. The transaction costs and frequent trading that would be required to mimic an underlying index every day in these fast-moving categories make them particularly suitable for notes, he says. He expects more notes to cover areas such fixed income, currencies and multi-asset products.
“ETPs are not riskless, but you know what the risk is,” Edwards says. “Providing the issuer remains solvent, the investor will receive exactly the index return minus a fee. There is only one counterparty, and it’s important to know who it is and to assess their ability to meet their future obligation.”