Focus on ETNs

If you think the menu of exchange-traded funds has gotten big, you should take a gander at exchange-traded notes. The number of notes has jumped to around 80, up from just a handful of choices a few years ago.

What are ETNs and how do they work?

To recap the basics: ETNs are debt instruments that pay a return linked to the performance of a single currency or commodity or an index of securities. The financial institutions that back ETNs promise to pay this return, minus annual fees. As debt, ETNs do not trade at or have a net asset value (NAV). Instead, their daily indicative value is based upon the index level that is published daily by an index provider or media outlet. The purpose of calculating the indicative value of an ETN is to approximate the intraday economic value of the note.

Financial advisors familiar with ETFs will see that ETNs share many similarities. For example, ETNs are bought and sold with brokerage orders just like traditional ETFs. Another important characteristic of ETNs is they have an arbitrage feature that’s designed to keep market prices closely hinged to the intrinsic value of the benchmarks they track. Large financial institutions that accumulate 50,000 notes can redeem them back to the issuing institution in order to capitalize on any premium or discounts that may exist.

Early AdoptersBarclays Global Investors (BGI) launched the iPath ETNs in 2006. The notes began as a small group of eight choices and have now grown into a menu of 26. The iPath notes come with 30-year maturities and are senior unsecured debt issued by Barclays Bank

The bulk of iPath notes focus on individual commodities such as coffee (JO), natural gas (GAZ) and copper (JJC). Other notes take a broader approach by focusing on a group of commodities. The precious metals notes (JJP), grains (JJG) and energy (JJE) take this approach. Still, other notes are concentrated on stocks (INP) or currencies (ICI).

“When we hear that clients need access to a particular asset class, we consider the investor’s experience, the internal portfolio management and the likely liquidity on the secondary market. Typically all parties are better off with an ETN structure for harder-to-reach markets,” said Noel Archard, iShares/iPath product development at Barclays Global Investors.

“Overall I maintain an approximate portfolio weight of 3.35 percent in three ETNs, all iPath: India and two commodity funds,” states R. David Telling, Jr., Managing Member of Telling & Company based in The Woodlands, Texas.

He continues: “Commodity, currencies and difficult-to-trade equity markets such as India make the ETN at the present the preferred instrument.”

Liquidity OptionsAs is the case with other debt securities like government or corporate bonds, ETN investors are not required to hold their notes through maturity. Since ETNs trade on major stock exchanges, they can be bought and sold in the secondary market. By selling an ETN prior to maturity, the investor forgoes the right to receive the full value of the index’s return at maturity.

Another route to liquidity is to simply hold the note until maturity. Most notes have 30-year maturities. Investors that opt to keep their notes for the full duration receive a cash payment calculated from the trade date to the ending period or maturity date. Applicable fees are deducted and reduce the value of their final payment.

One last liquidity feature consists of note redemptions, which are usually reserved for financial institutions with large note blocks of 50,000 or more.

Multiple AssetsPerhaps the greatest appeal of ETNs is that investors can obtain market exposure to asset classes in which they cannot directly invest because of lack of accessibility, investment restrictions or other complexities. “The operating structure of the ETN gives us far greater ability to bring products to market that would be incredibly difficult — if not impossible — under a traditional ETF structure,” says Archard.

Over the past several years more financial advisors have been incorporating commodities exposure into their clients’ portfolios. Two contributing factors fueling this boom are a bull run in commodity prices and the explosion of investment products, including ETFs and ETNs, aiming to track them.

The iPath notes offer exposure to two broad based commodity indexes in the DJ-AIG Commodity Index Total Return (DJP) and the S&P GSCI Total Return Index (GSP). The notes charge an annual fee of 0.75 percent.

Another area some advisors have been examining is currencies. Movements in foreign currencies do not always coincide with foreign equity markets. As such, currency may be a potential source of return but it can also act as a diversification tool to hedge against passive currency exposure.

On the currency front, the iPath notes offer exposure to the euro (ERO), British pound (GBB) and Japanese yen (JYN). Also, Van Eck’s Market Vectors offer the Chinese renminbi (CNY) and Indian rupee (INR).

Hedge Fund StrategiesIn May, First Trust Advisors and J.P. Morgan introduced an ETN that uses a 130/30 strategy (JFT). Such strategies typically begin with a group of selected stocks from an index like the S&P 500 or Russell 1000. The portfolio manager invests 100 percent of the fund’s assets in a screened list of chosen stocks and then simultaneously sells short 30 percent of the undesirable stocks. The cash proceeds generated from these short sales are redeployed back into the 100 percent long stock holdings. The fund’s stock allocation then becomes a mix of 130 percent long and 30 percent short.

Over the past several years, the 130/30 approach has become one of Wall Street’s hottest investment strategies, especially with hedge funds. Having notes that utilize hedge fund strategies is a significant step. No longer are such techniques exclusively available to just a small group of privileged investors.

Among the advantages of notes that use hedge-fund-like tactics are lower fees, greater liquidity and no minimum investment requirements.

Fees: One of the significant barriers of hedge fund investing is high costs. Instead of paying hedge fund managers annual management fees of 2 percent and 20 percent of profits, JFT charges just 0.95 percent.

Investment minimums: Hedge funds, especially ones piloted by hotshot managers, can have steep initial investment requirements. Also, certain investors, because they don’t have the minimum net worth requirements may not be able to invest in hedge funds. ETNs skirt both of these issues.

Liquidity: With regard to liquidity, some hedge fund managers may charge redemption fees for early withdrawals or in extreme circumstances ban withdrawals. Contrast this with ETNs. As long as the market is open for business, ETN investors can enter and exit their positions.

Inverse Performing NotesThe number of inverse performing ETNs is still small but offers some interesting opportunities. Currently there are nine commodity-focused notes.

InvescoPowerShares has a series of notes that short various commodities. If the commodities they track fall in value, the notes are designed to increase. While some of the ETNs don’t use leverage, others are designed to magnify inverse performance.