The success of a number of exchange-traded notes this year, including two that canvass the market of VIX volatility futures and others offering investors exposure to master limited partnerships, is raising the question of whether ETNs are about to truly take off and become part of every investor’s portfolio.
ETNs, unlike ETFs, offer investors direct exposure to an underlying index, minus expenses. They don’t own underlying baskets of securities like ETFs do, which not only eliminates tracking error but also gives ETNs access to parts of the investment universe that are hard to cover.
The catch -- and it’s been a big one since the market crash of 2008, 2009 -- is that ETNs are unsecured credit obligations backed only by the faith and good credit of their issuers. If an issuer goes under, investors essentially forfeit their entire investment. That chance seemed very remote when ETNs first launched in 2006, and perhaps it’s fading today. Some issuers say investors are getting over fears and are now curious about ETN attributes, including tax advantages.
“I am very confident that we’re going through what I’m calling ‘The Big Thaw’ when it comes to exchange-traded notes, and I think it started with the VIX products that iPath brought,” Bryon Lake, senior product strategy manager at Wheaton, Ill.-based Invesco PowerShares, said in a telephone interview. “We’re getting more questions and more feedback from investors that are looking for and comfortable with the exchange-traded note.”
ETNs represent about $14.5 billion out of the $1 trillion invested in exchange-traded vehicles, according to data compiled by IndexUniverse.com. And, inflows are building momentum:$1.21 billion in 2008; $4.18 billion in 2009 and almost $6 billion in 2010. Moreover, while ETN assets are less than 1.5 percent of total assets in exchange-traded products, the number of ETNs on the market is 131, or almost 12 percent of the 1,101 ETPs now listed in the U.S.
"It's clear that 2010 was the year of the ETN," said Keith Styrcula, chairman and founder of the Structured Products Association, a New York-based trade group with its finger on the pulse of developments in the world of ETNs. "With the proliferation of new issues and new issuers, the ETN came into its own as a liquid, tax-efficient investment vehicle," Styrcula added.
| VXX | iPath S&P 500 VIX Short-Term Futures ETN | Barclays Capital | 2,591.07 | 1,692.04 | 119,135.19 |
| AMJ | JPMorgan Alerian MLP ETN | JPMorgan Chase | 1,229.85 | 2,255.00 | 6,148.97 |
| VXZ | iPath S&P 500 VIX Mid-Term Futures ETN | Barclays Capital | 700.23 | 695.89 | 7,977.51 |
| DJP | iPath Dow Jones-UBS Commodity Total Return ETN | Barclays Capital | 322.65 | 2,822.92 | 3,995.61 |
| MLPI | UBS E-TRACS Alerian MLP Infrastructure ETN | UBS | 180.51 | 194.27 | 243.62 |
| RJI | ELEMENTS Rogers International Commodity - Total Return ETN | ELEMENTS | 141.84 | 662.92 | 872.68 |
| MLPN | Credit Suisse Cushing 30 MLP | Credit Suisse | 94.13 | 121.30 | 377.98 |
| RJA | ELEMENTS Rogers International Commodity - Agriculture Total Return ETN | ELEMENTS | 90.57 | 517.06 | 890.05 |
| UCI | UBS E-TRACS CMCI Total Return ETN | UBS | 81.81 | 129.99 | 54.94 |
| JJG | iPath Dow Jones UBS Grains Sub Total Return ETN | Barclays Capital | 80.59 | 188.89 | 973.92 | | |
VIX, MLPs, Commodities and Beyond
Much of the recent growth in ETN assets has centered on a few products, notably the iPath S&P 500 VIX Short-Term Futures ETN (NYSEArca:
VXX -
News) and the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEArca:
VXZ -
News). The two products now have $1.69 billion and $696 million in assets, respectively. The notes are designed to provide proxy exposure to the CBOE Volatility Index, or VIX, by reflecting the returns of short- and intermediate-term futures on the VIX index. Investors have been attracted to them as a potential hedge against unexpected market turbulence.
“ETNs allow you to track the more esoteric asset classes that would be tougher to do with an ETF, like the VIX, said Rick Romey, president of of ETF Portfolio Solutions, a Kansas-based Registered Investment Advisor. Romey added that his firm has not yet embraced ETNs, in part because of credit-related concerns.
The other big relative newcomer is the JPMorgan Alerian MLP Index ETN (NYSEArca:
AMJ -
News), a first-to-market exchange-traded note launched originally by Bear Stearns. After treading water for a few years, AMJ has caught on, pulling in more than $1 billion in new cash flow in the past year. It now has $2.26 billion in assets. Investors are attracted to AMJ for its yield, currently around 5 percent. ETNs are a slick vehicle for providing exposure to MLPs, which are nearly impossible to package into a tax-efficient mutual fund or ETF structure.
The third leg of ETN assets is in commodities, an area that includes the oldest and biggest ETN of all, the $2.82 billion iPath Dow Jones-UBS Commodity Total Return ETN (NYSEArca:
DJP -
News). DJP launched in 2006.
iPath has a broad family of futures-based commodity-related ETNs, which the company says gives investors the ability to play the emerging markets-related commodities boom of the past 10 years in a variety of ways.
“At different times, different commodities become interesting to people,” Tim Edwards, a New York-based iPath product development vice president, told IndexUniverse.com. “Right now, copper is one of them.”
The iPath Dow Jones-UBS Copper Sub Total Return ETN (NYSEArca:
JJC -
News) has returned about 25 percent this year and 43 percent in the past six months; it is currently the only ETP providing exposure specifically to copper. Two ETFs, the First Trust ISE Global Copper Index Fund (NYSEArca: CU) and the Global X Copper Miners ETF (NYSEArca:
COPX -
News) own companies that mine copper, though the companies held by the ETFs aren't necessarily exclusively focused on the mining of copper.
The iPath family of ETN also includes securities that allow investors to get exposure to currencies and to position their portfolios for changing interest rates.
Different Tax Treatment
Invesco PowerShares has built on the success of its commodities ETF franchise (including the $5 billion PowerShares DB Commodity Tracking ETF (NYSEArca:
DBC -
News)) and now offers investors the option of gaining similar exposure in an ETN wrapper. DBC’s ETN counterpart, the PowerShares DB Commodity Long ETN (NYSEArca:
DPU -
News), had gathered $6.7 million as of Dec. 29.
Apart from the broad-based DPU, the company has replicated ETF strategies using ETNs in four other commodity markets:oil, base metals, agriculture and gold. PowerShares has extended the market on the ETN side with short ETNs and ETNs offering double-exposure long and short.
“The ETN structure provides us some flexibility in order to access markets that may be more difficult to access through the ETF vehicle,” Bryon Lake, the PowerShares executive said. “For example, our double-long and double-short gold ETNs -- (NYSEArca:
DGP -
News) and (NYSEArca:
DZZ -
News) -- have seen significant uptick in activity and assets due to all the attention gold has been getting for the last year or so,” Lake said.
There are also potential tax advantages to owning ETNs, which, for commodity ETNs under prevailing IRS interpretations, are taxed like zero-coupon bonds. That means investors don’t owe tax on the note until they sell, the note gets called (if it’s callable), or the note matures. Commodity ETF investors have their positions marked-to-market each year, creating an annual tax bill. ETN investors also have to fill out 1099 tax forms, as opposed to the K1 forms reserved for investors in futures. That’s true even for ETN investors with futures-based holdings.
“We hear from some investors that they would prefer to not get K1s,” said Lake. “And they can generally get the same exposure through ETN vehicles that may offer them a different tax treatment.”
Lingering Doubts
Currently, the biggest issuers of ETNs are firms that thrived during the near-collapse of the financial system in September 2008. Indeed, companies such as iPath ETN issuer Barclays; J.P. Morgan, the company behind the MLP exchange-traded note “AMJ;” and Deutsche Bank, the sponsor of the ETNs marketed by PowerShares, all took advantage of the turmoil their rivals barely survived.
“The market crash got rid of a lot of players in the marketplace. So those who were left standing like Barclays who had the creditworthiness, could then grab a bigger market share,” said Richard Keary, president of Global ETF Advisors LLC, a New York-based firm that helps companies bring exchange-traded products to market.
Recently, however, that has changed. Citigroup recently launched the volatility-related C-Tracks Exchange-Traded Notes Based on the Performance of the Citi Volatility Index (NYSEArca:
CVOL -
News). The note has attracted $13.8 million in assets since its rollout in mid-November. A slew of other firms are also jumping into the ETN arena, among them Credit Suisse, UBS, the
Royal Bank of Scotland as well as a firm called VelocityShares that was formed in part by an executive who helped launch iPath's ETNs
What could that mean? Are investors so complacent that firms, such as CitiGroup or RBS, formerly on life-support can now issue debt products and attract attention? Or have Citi and RBS turned the corner and now is seen as trustworthy? Or, mostly likely, do investors see these as trading products designed for one- or two-day moves, and not as long-haul investments where the credit risk most matters.
Maybe that’s the secret of the ETN rebirth:the notes have focused on providing trading tools rather than long-term investments, reducing the likelihood that investors will be caught in a failed situation.
The uncertainty brings the discussion full circle back to the credit risk implicit in any ETN. After all, three ETN backed by Lehman Brothers closed in September 2008 after the firm declared bankruptcy, and any investor who held to the bitter end lost out.
“I know it’s a long shot,” said Rick Romey, the Kansas-based financial advisor. “The odds of a company going out of business and the ETN holders being left holding the bag is very small probability. But in the last couple of years, we’ve seen a lot of long shots come to fruition and hurt a lot of people.”
Time will tell.
Disclosure I am long AMJ approx 2 weeks ago.