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By Paul Amery

ETNs (exchange-traded notes) have never gone away, but the spike in counterparty credit risk concerns in 2008 and early 2009 meant that investors were not exactly in a hurry to incur unsecured bank exposure, something that comes as part and parcel of these instruments.

In a blog early last year, I even speculated – incorrectly, as it turns out – that ETNs might have been killed off for good by the Lehman collapse. For although ETNs remain the much smaller cousin of ETFs – with just over US$9 billion invested in the US, compared to over US$750 billion in ETFs, according to the latest data from the National Stock Exchange – the ETN market has more than doubled in size over the last year, compared to a two-thirds increase in ETF assets.

Barclays, through its iPath subsidiary, dominates the ETN market and last week the firm announced a major expansion of its European range with the launch of nine new commodity trackers.

But why would an investor take on commodity index exposure via an uncollateralised debt instrument such as an iPath ETN when it’s possible to buy the same thing in a collateralised exchange-traded commodity from ETF Securities or Source for a lower annual fee? iPath’s ETNs charge 0.75% in annual management fees, compared to 0.49% for most ETCs.

When I spoke to Uwe Becker of Barclays Capital earlier this week, he pointed out that ETNs offer perfect index tracking (before fees) whereas ETCs have embedded costs relating to the provision of the swaps that underlie the products and the collateral they use, which can cause greater divergence from the index return.

For example, ETF Securities’ Commodity Securities prospectus details a 45 basis point fee payable to UBS for the provision of the swaps that guarantee the commodity index return (the fee is included in the “capital adjustment” which ETF Securities uses to calculate the net asset value of its ETCs from the individual commodity index). Source’s T-ETCs have the same 45 basis point implicit swap cost. In both cases the swap charge is borne by investors in addition to the 49 basis point management fee. Those two components, plus a 5 basis point index licensing fee, add up to around a percent in annual charges.

However, the ETC providers argue that to compare ETCs and ETNs on a like-for-like basis one should also take into account the cost of unsecured funding for Barclays (in iPath’s case), which is currently around 100 basis points over US treasury bills. This, they argue, reflects the additional return that an investor requires for taking on the bank’s credit risk via an ETN.

Barclays’ (BCS) five-year credit default swap spread currently stands at pretty much the same rate, as shown in the chart below, provided by credit information specialists CMA.

click to enlarge

Barclays_CDS

But, reply ETN issuers, one needs to consider the value of the option embedded in most ETNs to redeem at the net asset value with the issuer on a daily basis, subject to a US$2.5 million minimum. That’s worth something to an investor, since it can be seen as reducing the naked credit risk.

On the other hand, sceptics point out, the option is worth somewhat less for being granted by the same entity as the one issuing the bond, since it will be of limited or no use if the issuer gets into trouble.

Plus, they say, working against investors is an option granted to iPath to call the bonds and redeem at any end-of-day index value during a 20-day notice period.

All in all, an ETN/ETC comparison is therefore very complex, and headline fees give little indication of real investor costs.

Whether these technicalities are the major concern of an investor who wants commodity exposure is a moot point. Arguably, the underlying commodity’s price outlook and the roll yield (when investing in a futures-based product) are more important, since they potentially have a much greater impact on the final performance.

All the same, it’s important to try and assess competing products on a like-for-like basis as far as possible. With the proliferation of new commodity trackers, that’s not getting any easier.

Could a reassessment of regulations help?

“The reason we have all these structures is because regulators have said that you can’t put single commodities into a UCITS-compliant fund. If they allowed this, it would be easier to compare the products on offer from different firms and, in the medium term, that has to be the right answer,” said Ted Hood, CEO of Source.

For the time being, though, investors will have to keep reading those 200-page prospectuses, where the devil is, as they say, in the detail.

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Source: ETNs and Counterparty Risk: The Devil's in the Detail