Exchange-Traded Notes–Definitions and Uses: Part 1

Barclays launched the first exchanged-traded notes (ETNs) in July 2006 under the iPath brand. Those ETNs were Dow Jones–AIG Commodity Index Total Return ETN and S&P GSCI Total Return Index ETN. Since then, more than 300 ETNs have been created in the U.S. and Europe, and more are on the way.

The acronym ETN has created some confusion and misunderstanding. Many retail investors seem to lump ETNs together with exchange-traded funds (ETFs). For example, some published reports suggest that inclusion of precious metals in a portfolio can be achieved using ETFs or ETNs, and the reports don’t make any distinction between the two securities. This unfortunate co-categorization is understandable in light of the acronym similarities. But, while ETNs do share a few similarities with ETFs, they are very different from ETFs in a number of critical respects.

REUTERS/Arnd Wiegmann

Given the growing use of ETNs, our objective in this series of articles is to provide an introduction to ETNs. Our articles will provide descriptive information about ETNs, a simple analysis of how closely ETN market prices track their indicative values, and a discussion of why ETNs may appeal to various investor classes.

Definitions

ETNs are similar to zero-coupon bonds, which are sold in very low denominations with mid- to long-term maturities, early-redemption clauses, and variable interest rates. They have an associated structured product – what is referred to as the corresponding index.  The investor will receive a cash payment that is linked to the performance of the corresponding index during the period beginning on the trade date and ending at maturity, less investor fees.  Typically ETNs do not offer principal protection.

Once an ETN is issued, it typically trades on major exchanges such as NYSE Arca in the U.S. or Xetra in Germany. Unlike ETFs, whose tax treatment is similar to that of ordinary stocks, the tax treatment of ETNs is still unclear. We will briefly discuss each of these features of ETNs below and in the next article.

Most ETNs are issued by large financial institutions. The ETNs’ prospectuses make clear that the notes are unsecured obligations. As unsecured debt obligations of the issuing institution, one of the major risk factors that should influence the price of ETNs is the financial viability or default risk of the issuing institution. This aspect of ETNs represents a significant difference from ETFs. ETNs, as debt instruments, should have a default-risk component present in their market prices. Since ETFs are not debt instruments, and in fact usually have physical assets held in trust backing each ETF share, they generally do not have a default-risk component in their market prices. Stated differently, ETN investors face the possibility (although with hopefully small probability) that the issuer may be unable to pay the obligation at maturity, something which ETF investors do not face.

ETN prospectuses are also very clear about the fact that no interest payments will be distributed to shareholders. ETNs typically are issued at the full principal amount, and while the maturity dates range from 2020-2038, the majority of the ETNs have maturities of 30 years from inception.

In terms of share creation and redemption ETNs have similar mechanisms as ETFs, but ETN processes do not seem to be as fluid. The typical ETN prospectus contains an early-redemption clause, which allows investors to redeem their ETN shares at any time for their “redemptive” or “indicative” value, provided investors redeem a certain number of shares (typically at least 50,000) and follow the redemption process outlined in the prospectus. The early-redemption procedure is intended to be similar to the redemption feature of ETFs; however, there are two significant differences: First, ETFs have privileged or authorized investors (specialists and market makers) whose job it is to monitor the difference between market prices and NAVs and to act to reduce that difference. ETNs do not appear to have such agents who are directly responsible for monitoring and reducing potential mispricing. Second, the redemption procedures for many ETNs require an investor to notify the issuer of an intention to redeem at least one day prior to the actual redemption, and some ETNs require notification as much as ten business days in advance of the actual redemption. If the early-redemption clause is intended to serve the same arbitrage-minimizing role that the share creation and redemption mechanism serves for ETF investors, then the time lag between the decision to redeem and the actual redemption of ETN shares may be an obstacle to the efficient pricing of ETNs. It may be that those ETNs with the longest lags between redemption notification and redemption execution have the least efficient prices.

On the opposite side–share creation–ETNs typically reserve the right to issue more shares of the security at any time under the same terms as the original issue. Although the ETN share-creation process is meant to serve a purpose similar to that of the ETF share-creation process, there are some significant differences. ETF share creation is a relatively simple matter of the authorized investor depositing the necessary shares of individual stocks with the trust. It can and does happen on a weekly or even daily basis. To create new shares of an ETN requires an entirely new seasoned offering. It seems to happen no more frequently than monthly, and sometimes several months pass between episodes of share creation. Further, the party responsible for initiating the ETN share creations is not an authorized investor who has the opportunity to profit from such transactions and therefore does not have an incentive to actively engage in the share-creation process. These considerable differences between ETFs and ETNs in the share-creation process suggest why ETN shares are created much less frequently than ETF shares.

Taken as a whole, the creation and redemption processes of ETNs seem much less fluid than the same processes for ETFs. The creation process is infrequent and cumbersome for ETNs relative to ETFs. Recalling that share creation helps to reduce the price of overpriced ETFs and recognizing the obstacles to the creation of ETN shares, the assumption can be made that mispricing on the overvaluation side of an ETN is not only possible but perhaps to be expected. To a lesser degree the redemption process also seems less efficient for ETNs, suggesting mispricing on the undervaluation side is possible as well. The main point is that ETFs seem to have better mechanisms for keeping their prices relatively efficient. Because of this, mispricing among ETFs is expected to be minimal. The same cannot be said for ETNs. Mispricing can and likely is a prevalent issue and one worthy of investigation.

In our next article we will continue our definition of ETNs. We will cover the calculation of the redemptive or indicative value of an ETN, the trading of shares, and the tax treatment of ETNs.