ETNs and ETFs should not be used interchangeably, as key differences set them apart.

By Gary Knight, Vice President, Trading, TSX Markets

This article was originally featured in the September 2013 issue of

Canadian ETF Watch.

More than two decades ago, the world’s first index-linked Exchange Traded Product (ETP) was listed on Toronto Stock Exchange (TSX). Since then, the ETP industry has enjoyed phenomenal growth both in the Canadian marketplace and globally.

Today, the global ETP industry has grown to reach over $2 trillion in assets under management (AUM).* In Canada, a similar growth trend is apparent – the widespread adoption of these products has resulted in about $70 billion in market exposure. Alongside this impressive growth in assets, the industry’s scope has evolved to provide investors plenty of choice in accessing both domestic and international markets.

As the industry has grown, investor awareness has followed closely. There is increasing demand from investors who are turning to ETPs as an efficient means to portfolio diversification. Exchange Traded Funds (ETFs) have commanded much of the attention so far, as they dominate in terms of assets and number of products listed. Yet, there is another product that is capturing the interest of investors seeking bespoke products that deliver enhanced market access.

Exchange Traded Notes (ETNs) give investors asset allocation with targeted sector exposure, as well as competitive expense ratios. However, ETNs and ETFs should not be used interchangeably, as key differences set them apart.

A Tale of Two Products: ETNs and ETFs

An ETN is a senior, unsecured debt obligation that is typically issued by a major bank. Put simply, a bank issues a note that promises to give investors a return based on the performance of a specific index or other benchmark (less fees).

In some ways, ETNs are similar to ETFs because they both track an underlying index or single reference asset such as commodity futures, foreign currencies and emerging markets. They are convenient, cost-effective, tax efficient and – at the most basic level – both products can be bought and sold on an exchange throughout the trading day, just like conventional stocks.

However, ETNs and ETFs have a fundamentally different structure and other key distinctions. Before investors or advisors decide that ETNs are a good fit for their investment portfolios, an appropriate understanding will help them make an informed decision.

What is an ETN?

ETNs are positioned as a flexible investment vehicle that can utilize customized strategies to enhance exposure to a diversity of asset classes and, in some cases, serve as effective hedging tools. Here’s a look at four key characteristics that define ETNs.

• First, ETNs are debt instruments issued by a financial institution, whereas ETFs represent a share of an underlying portfolio of securities. Unlike ETFs that buy or hold assets to replicate the performance of a particular index or strategy, ETNs have an indicative value that reflects the performance of that index or strategy. The ability to redeem ETNs at the indicative value for cash helps to keep the market price close to that value. Therefore, the trading price of an ETN will reflect both the indicative value and the supply and demand in the marketplace.
• Second, by their very nature, ETNs allow investors to access specialized market sectors, niche asset classes and trading strategies that may otherwise be difficult for average investors to buy or replicate. For example, market segments such as commodities may be hard to reach in a cost-effective way using other types of investments. As a result, ETNs have gained popularity as a strategic alternative to broaden the scope and reach of an investment portfolio.
• Third, ETNs are immune to tracking error – an ever-present risk in the ETF space. As debt instruments, ETN investors are guaranteed to receive a fixed rate of return because ETNs are, essentially, prepaid contracts with a bank. While an ETF may fall short of its benchmark, when a bank issues an ETN it promises to pay the investors the total return of their indices (minus fees), either at full maturity or upon early redemption (subject to a one-time redemption charge).
• Finally, as unsecured debt securities, ETNs do not provide principal protection. For that reason, investors could be exposed to credit risk as the repayment of principal and payment of returns hinge on the issuer’s ability to pay. Therefore, it is important to consider the issuer’s credit rating when making a decision to invest in ETNs. However, if an investor has an appetite for credit risk, an uncollateralized product with minimal tracking error is not necessarily a bad thing. It is also worth noting that ETNs can be redeemed by the holder of the ETN or called for redemption by the ETN issuer before their maturity date. The ability to redeem notes prior to maturity can help investors better manage credit risk.

Types of ETNs

There are currently 12 ETNs listed on TSX, with a market value of over $1.3 billion. These products help investors meet their unique needs and diverse investment strategies. Here is a look at several categories where ETN investors can gain exposure to a variety of asset classes.

Fixed Income

There has been much discussion and debate in the financial services industry and media about the risks that could develop from a potential rise in interest rates. To help mitigate these risks, ETN investors can access a particular fixed income strategy for additional portfolio diversification and flexibility.

Generally speaking, fixed income ETN investors can implement a strategy based on expectations of future economic cycles. For instance, they can execute tactical views regarding expectations of shifts in the U.S. Treasury yield curve or apply a hedging strategy to mitigate their sensitivity to the yield curve or specific yield shifts.

Exposure to Commodities

Commodity ETNs allow investors to further diversify their investment portfolio, while also providing tactical asset allocations that can be fine-tuned and tailored according to their desired exposure to commodities, or allow them to hedge against inflation.

The iPath Pure Beta Crude Oil CAD Hedged ETN (TSX:PBO) is an example of a commodity-linked ETN. It tracks the Barclays WTI Crude Oil Pure Beta Index, hedged to the Canadian dollar. This ETN provides exposure to hard-to-reach markets through an index that offers a more representative exposure to the underlying commodity than traditional front month futures-based indices.

Volatility Exposure

A number of ETNs attempt to either reduce or minimize investor exposure to volatility or capitalize on overall uncertainty in the market by following volatility futures. Most investors have benchmarks that they watch closely to keep tabs on the market, such as the widely followed CBOE Volatility Index, which is an important benchmark to gauge the volatility of the S&P 500.

Here is a look at two volatility-linked ETNs listed on TSX:

• iPath S&P 500 Dynamic VIX CAD Hedged ETN (TSX:DVX,) is linked to the S&P 500® Dynamic VIX FuturesTM Total Return Index, hedged to the Canadian dollar. This ETN offers exposure to a dynamic strategy that aims to reduce the effects of contango during normal or low volatility regimes.
• iPath S&P 500 VIX Short-Term Futures CAD Hedged ETN (TSX:VIX) is linked to the S&P 500® VIX Short-Term FuturesTM IndexTR and offers exposure to shorter-term futures on the CBOE Volatility Index.

Exposure to Foreign Currencies

Many investors have also turned to ETNs to gain exposure to foreign currencies, either to hedge against exposure found elsewhere in their investment portfolio or to speculate on movements in global exchange rates.

Currency-linked ETNs can help investors gain exposure to foreign exchange spot rates, which measure the relative value of foreign currency relative to the U.S. dollar. These could include the euro, the Japanese yen or the British pound.

Some ETNs also allow investors to borrow in low yielding currencies in order to establish long positions in higher yielding currencies, thereby exploiting interest rate differentials across different markets. However, there are always risks involved in this strategy, such as rapid appreciation of a specific currency against the U.S. dollar or other unforeseen fluctuations.

Buy-Write Strategy

Option overlay strategies have been used primarily by day traders, high net-worth individuals or institutions who can skillfully manage this complex approach involving many moving parts. However, the buy-write strategy – commonly referred to as covered call – is gaining popularity as a simple, boiled down approach which achieves a similar objective. At its root, a buy-write is an investment approach where covered call options are written on the underlying securities, and premiums are earned from the option writing.

For those investors who prefer to get their covered call exposure through an ETN, some notes track the CBOE S&P 500 BuyWrite IndexSM, which measures the total rate of return of a hypothetical buy-write on the S&P 500.

ETNs listed on TSX:

1. iPath U.S. Treasury Steepener ETN (SST, SST.U)
2. iPath U.S. Treasury Flattener ETN (FFL, FFL.U)
3. iPath Pure Beta Crude Oil CAD Hedged ETN (PBO)
4. iPath S&P 500 VIX Short-Term Futures ETN (VXX, VXX.U)
5. iPath S&P 500 VIX Mid-Term Futures ETN (VXZ, VXZ.U)
6. iPath S&P 500 Dynamic VIX CAD Hedged ETN (DVX)
7. iPath S&P 500 VIX Short-Term Futures CAD Hedged ETN (VIX)
8. iPath EUR/USD Exchange Rate ETN (ERO, ERO.U)
9. iPath GBP/USD Exchange Rate ETN (GBX, GBX.U)
10. iPath JYN/USD Exchange Rate ETN (JYN, JYN.U)
11. iPath Optimized Currency Carry ETN (II, II.U)
12. iPath CBOE S&P 500 BuyWrite Index ETN (BWV, BWV.U)

All figures year-to-date August 31, 2013

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