Six things you should know about ETFs and ETNs

These investment tools are popular — but also come with risks

Larry MacDonald

Globe Investor Magazine Online, November 4, 2008

Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) are two of the most popular tools in investors’ pockets. Investors poured almost $900-million into iShares ETFs in the month of September, says Heather Pelant, head of iShares Canada. Meanwhile, Canadian mutual funds reported outflows of about $4.5-billion in the month.

Som Seif, president of Claymore Investments Inc. believes this volatile market environment has only made ETFs more attractive and highlighted their benefits — low fees, transparency and flexibility The reality is that investors are seeing finally that active management doesn’t add value, Mr. Seif said.

But ETFs and ETNs can sometimes go awry. Here are six things you should know about how they work.

Credit risk in ETNs.

ETNs expose investors to the risk of losing all or most of their principal. That’s because ETNs are set up as unsecured, long-term debt obligations of the issuer, Ms. Pelant explains. ETF investors don’t face the same default risk because ETFs own a pro rata stake in a basket of stocks, bonds, or derivatives held by a custodian in trust and legally separate from the issuer, she says.

The recent demise of Lehman Brothers illustrates the default risk. Holders of Lehman’s Opta family of ETNs now have their deposits frozen until bankruptcy trustees divide up what’s left of the company amongst creditors. They will likely receive pennies on the dollar.

When Morgan Stanley’s viability came under question in September, its family of Market Vectors ETNs sold off dramatically. The Market Vectors’ Remnimbi/USD ETN (CNY) plunged more than 25 per cent versus a 1-per-cent drop in a comparable ETF, observes Greg Newton, a veteran financial journalist who writes the NakedShorts blog.

ETFs and daily rebalancing

The ProShares Russell 2000 UltraShort ETF (TWM) is designed to provide twice the inverse return of the Russell 2000 index. But when the latter fell by 8.1 per cent in September, the ETF went up only 8.7 per cent.

That’s because the ETF commits to delivering twice the daily performance of the index, not twice the monthly performance. To illustrate the difference, see Technical Note 2 at the bottom of the story for a simple numerical exercise condensed from the prospectus for a group of Horizon BetaPro ETFs, which use daily rebalancing.

Discounts on bond ETFs

On Oct. 11, the iShares Lehman Aggregate Bond Fund (AGG) closed at a 9-per-cent discount to net asset value. In its five-year history, the closing price has rarely been off more than 0.5 per cent. Other bond ETFs with corporate bonds had significant markdowns too.

Whenever this happens, it is the inability of the market to accurately price the underlying securities, explains Howard Atkinson, president of BetaPro Management. When the market maker is not sure what the next market value will be for the underlying securities, they will widen out the spread to protect themselves.

In this instance, it appears to be related to mounting fears of corporate defaults, which has led to a general decline in liquidity across the fixed-income market sectors, Matthew Tucker of Barclays Global Investors told Murray Coleman of IndexUniverse.com. This has been driven by the removal of significant fixed-income counterparties as well as general credit concerns about other counterparties. In addition. participants are less willing to commit capital at this time.

Regulatory risk

Regulatory changes, such as the recent ban on short selling U.S. financial stocks, can have an adverse impact. Most affected by the ban were the inverse ETFs for U.S. financial stocks: ProShares UltraShort Financials (SKF) and ProShares Short Financials (SEF). The day the ban was announced, trading was temporarily halted due to uncertainty over how unit prices would be affected. Holders ended up missing sizable gains as financial stocks tumbled that day.

When trading resumed, new units could not be created. As a result, the ETFs traded at a premium to net asset value (see Technical Notes, Part 3 for more detail). Mr. Atkinson estimates the premium averaged 1 per cent a day until the ban ended on Oct. 9 and issuance of new shares resumed.

Credit risk in ETFs

Leveraged ETFs use derivatives to provide returns to investors. To the extent an ETF uses over-the-counter derivatives, such as swaps and forwards, it is exposed to the risk of default on the part of the counterparties providing the derivatives. There have been no reported losses to date during the current crisis, but the risk is elevated at this time. The most an ETF could lose is the unrealized gains on the swap or forward, says Mr. Atkinson. Mr. Seif concurs: Risk is generally not on 100 per cent of the assets. If you swap $100 of cash for the return of some equity index and the equity index goes up 10 per cent, you still own $100 of cash — you just risk the 10 per cent return in the event of a default.

The potential for losing return is reduced through diversification.

The ProShares ETFs use multiple counterparties. Horizon BetaPro ETFs have one, but are adding a second, Mr. Atkinson says. Horizon BetaPro will replace counterparties if their credit rating falls below A-. And swaps are short term, which allows frequent resetting of positions.

Commodity ETFs using futures contracts

ETFs that use commodity futures have tracking errors over periods of time, warns Larry Berman, chief investment officer at Toronto-based ETF Capital Management. The divergence can be large. For example, just over a year after its inception in 2006, the United States Oil ETF trailed its benchmark, West Texas Intermediate crude oil, by 13 per cent. Volatility from the financial crisis is adding to the tracking issues. Changes in the futures’ prices affect the magnitude of tracking errors (see Technical Note 4).

Technical Notes:

1. How ETFs and ETNs work

ETFs don’t buy and hold a portfolio of securities like mutual funds do. The key innovation is the designation of an authorized participant or market maker. They assemble large blocks of securities and sell units representing a proportionate interest to investors.

As with closed-end funds, there is a danger investors could bid ETF unit prices above or below the underlying value of the basket of securities. But the market maker has an incentive to prevent such premiums and discounts from emerging.

If a discount emerges, they profit by purchasing ETF units in the open market and redeeming them for blocks of the underlying securities. Selling these securities in the market delivers a gain, and the process will continue until ETF unit prices are bid up and security prices are bid down by enough to eliminate the discount.

If a premium emerges, the market maker profits by obtaining securities and adding them to the basket to create new ETF units. The sale of the new units to investors in the open market yields a gain, and the process will continue until unit prices are bid down and security prices are bid up by enough to eliminate the premium.

Leveraged ETFs often use futures contracts, forwards, swaps, and other derivative to replicate a multiple of the returns on the underlying index. Derivatives provided over the counter, notably swaps and forwards, are issued by counterparties — usually a financial institution. They are agreements through which the purchaser agrees to pay a fixed rate of interest to the counterparty in exchange for the promise to provide a multiple of the return on an index.

Inverse ETFs require the counterparty to provide the inverse of the index’s return. To do this, the counterparty needs to hedge their exposure by short selling the underlying securities.

ETNs track the performance of an underlying index or strategy like ETFs do but are essentially promissory notes issued by the provider. They don’t have a tracking error and often provide exposure to markets not covered by ETFs.

2. How twice the daily performance differs from twice the performance for a longer period

Imagine an index that goes up 10 per cent from 100 to 110 in the first period and down 10 per cent in the second to the 99 level, for a cumulative decline of one per cent. A leveraged (double-long) ETF without daily rebalancing would go up 20 per cent to 120 in the first period and down to 98 in the second, to provide a cumulative decline of 2 per cent (double the index).

A leveraged ETF with daily rebalancing would go up 20 per cent to 120 in the first period and down 20 per cent (double the 10-per-cent index drop) in the second period, which would leave the ETF at 96 (120 x 0.8), for a cumulative decline of 4 per cent. The reason for the difference is that rebalancing changes the amount of principal compounded each period.

Leveraging, frequent rebalancing, and greater volatility (as currently exists) make the divergence more pronounced. Daily rebalancing of leverage can also work to an investor’s advantage, such as during periods of steady increases or steady declines of the underlying Index, adds the Horizons BetaPro prospectus.

3. Why new units of the inverse financial ETFs could not be issued during the short selling ban

The creation of new units required creating more swaps with inverse exposure to the underlying indexes. Counterparties were unable to provide such swaps because it was unclear, despite an exemption order, whether or not they were able to hedge their exposure by short selling financial stocks. They didn’t want to take on the risk of angering regulators, especially when their balance sheets were constrained, explains Morningstar Inc. analyst John Gabriel.

4. How tracking error arises in commodity ETFs

Some commodity ETFs track commodity prices by taking a position in the contract closest to expiry. If contracts further away from expiration have higher prices (contango), the contract will be purchased at a higher price than the spot price. As time passes and the contract nears expiration, its price will fall to the spot price. This means a loss is incurred when the expiring contract is rolled into the next contract. This, in turn, causes the commodity ETF to decline even if the spot price has remained the same or risen by an amount too small to offset contango.

If futures prices are in backwardation (that is, contracts farther away from expiration have lower prices), the nearest term contract will be purchased at a lower price than the spot price. As the near-term contract approaches expiration, its price will rise toward the spot price and yield a gain when rolled over, causing the ETF to appreciate even if the spot price is stable or falling by an amount too small to offset backwardation.

Special to The Globe and Mail