Exchange-Traded Notes–Definitions and Uses: Part 3

In our prior articles we focused on ETNs’ definitions, tax treatment, and indicative value. In this article we look at their possible uses.

The primary appeal and benefit of ETNs to most investors relates to the exposure they offer investors to nontraditional asset markets and classes. If the market price of an ETN closely correlates with its indicative value, ETNs offer retail and institutional investors an opportunity to gain exposure to markets that may otherwise be accessible only through derivatives or through securities that invest in derivative products. This is the most appealing aspect of ETNs: they offer investors both long and short exposure to individual currencies and commodities and to diversified currency and commodity markets in general. They do so: (1) at an affordable price, (2) with known transaction costs, (3) with a fair amount of liquidity, (4) without the investor having to enter the world of derivatives with its complexities and leverage, and (5) without the investor having to short a security or asset.

REUTERS/Olivier Pon

Retail Investor Appeal

ETNs appeal to retail investors who may feel constrained to investing in the equity and bond markets. The reasons for retail investors’ confinement to the role of spectator in non-equity markets are several, including time and resource constraints, knowledge and experience limitations, and an aversion to the downside risk inherent in futures contracts and short positions.

ETNs provide an opportunity for retail investors to overcome many of the barriers that have kept them largely corralled in the equity and bond markets in the past. Purchasing an ETN is no more difficult or expensive than purchasing a stock. And, as with purchasing a stock, buying an ETN technically puts an investor in a long position, meaning no margin requirements apply, even if the ETN itself offers double the inverse of the return of a given currency, commodity, or index. Since there is no leverage involved in taking a simple long position in an ETN, an investors’ potential losses are limited to the price of the ETN. For all intents and purposes ETNs represent a very simple way for retail investors to access markets that were once very difficult to enter.

Mutual Fund and Pension Fund Appeal

ETNs offer a similar appeal as they do to retail investors to one set of institutional investors. Most mutual funds and pension funds are prohibited or limited by their charters from investing in derivatives. But it is not clear whether a charter that prohibits buying and selling derivatives also tacitly prohibits taking positions in securities traded on stock exchanges that are linked to derivatives products. Considering the importance of tracking error in the mutual fund industry, it is likely that the vast majority of mutual fund and pension fund managers have no interest in investing in any product whose return is dependent upon the derivatives markets. But it is not outside the realm of possibility that at least some mutual fund managers would embrace the opportunity to take a small position in a currency or commodity market to either add an extra boost to their funds’ returns or to provide a portfolio hedge. ETNs may provide a way to do so. Mutual fund and pension fund managers who are limited by their charters to purchasing and selling certain types of securities may be allowed to buy ETNs, which can offer them exposure to numerous currency and commodity markets that were previously limited to them.

Further, many fund charters prevent or limit mutual fund and pension fund managers from short selling. Again, it is unclear if a charter that prohibits short selling also tacitly prohibits taking a long position in a security whose return is decidedly the inverse of the return of some other asset, market, or index. But it is easy to conceive of a mutual fund manager who wishes to have the ability to short sell either to boost a fund’s return or to hedge a fund during turbulent times. In addition to providing an opportunity for exposure to previously off-limit markets, ETNs can offer either short or long exposure in those markets. The ability of ETNs to offer returns that mirror short positions to investors who are technically taking long positions may appeal to mutual fund and pension fund managers.

Hedge Funds

Much of the above may also create interest in ETNs by hedge funds, but most hedge funds are not constrained in the way retail investors and mutual fund and pension fund managers are. For that reason the primary appeal of ETNs to hedge funds revolves around the more exotic ETNs–those that offer either double-long or double-short exposure to a particular commodity or currency.

Further, if standard margin requirements are applied to ETNs, a hedge fund could buy a gold double-short ETN on 50% margin, which would essentially provide that hedge fund a quadruple-short position in gold. This tactic is possible with most ETNs. The opportunity to achieve extreme long or short exposure in a specific currency or commodity or in a diversified basket of currencies or commodities may appeal to certain types of hedge fund managers. Products such as the more exotic ETNs create an environment where, in order to deliver significant alpha for investors, a hedge fund manager needs to be right about the directional movement of a few currencies or commodities. It may be particularly reassuring to hedge fund managers and their investors to know that the hedge fund wouldn’t actually be buying or selling any of the currencies or commodities, since buying and selling could move the prices of the assets if the hedge fund is operating with large enough amounts of money. Instead, the hedge fund is buying a security that is distinctly separate from the currency or the commodity of interest, although the security’s indicative value is directly tied to the commodity or currency. And because of the early-redemption clause and the ability and willingness of ETN issuers to issue more shares as needed, it is possible that the large buy orders and sell orders from hedge funds could be structured to have minimal impact on the price of the ETN itself. This ability to take extreme short and long positions in currencies and commodities without affecting the prices of those commodities or currencies would appeal to hedge fund managers.

Leveraged ETFs–those offering anything other than a simple long position in a collection of stocks–usually rely on derivatives to secure the promised returns to investors. An analysis of the holdings of a leveraged ETF reveals a combination of forwards and futures contracts. While synthetic securities created through combinations of equities and derivatives are not uncommon, it is questionable whether such synthetic securities do an effective job of actually earning twice the inverse of the daily return of gold. Further, it is questionable whether the authorized investors for this ETF are able to accurately price the underlying net asset value. The ETN cousins of these ETFs do not suffer from these problems. Instead of using a mix of derivatives to generate double the inverse of the daily return of gold, the issuing firm simply guarantees investors that the redemption value will accrue interest at precisely double the inverse of the daily return of gold. As long as the issuing institution does not default on the notes, investors will ultimately get precisely that return.

Conclusions

The return investors earn on an ETN comes from the guarantee of the issuing institution to pay whatever return is promised in the prospectus. Since there is no collateral backing up ETNs and the return earned by investors is literally paid at maturity by the issuing institution, the financial health of the issuing institution should be of prime concern to anyone investing in ETNs.

ETNs offer investors affordable, highly liquid, and risk-controlled access to asset classes such as currencies and commodities that are difficult to otherwise access with modest resources and without assuming considerable risk. Further, exotic ETNs offer investors opportunities for double-long and double-short positions in a variety of asset classes, again with relative affordability, high liquidity, and controlled risk. And, it may be the case that these exotic ETNs do a better job of actually earning double-long and double-short positions in these asset classes than do their ETF counterparts.