Troubled By ETF Tracking Failures? Try ETNs

ETFs got some bad press in the April 19 Wall Street Journal for, in come cases, failing to track the indices they were designed to follow. Victoria Bay Oil ETF (USO) and Claymore oil ETFs -- (UCR) and (DCR) -- were cited as particular cases of failure.

Most ETFs did just fine, we suspect, but these commodity oriented ETFs failed their investors. The article said the Claymore ETFs sometimes actually moved counter to the moves of their index. USO was off 15% from its index.

That’s where ETNs (exchange traded notes) come in as near perfect solutions to the tracking problem. Barclays recently began offering ETNs for commodities, as well as for India (INP). They offer an oil ETN (OIL), and two commodity ETNs, one based on the Dow Jones – AIG Commodity Indes (DJP) and one on the Goldman Sachs Total Return Index (GSP).

Their ETNs are actually debt instruments issued as liabilities of Barclays, but the principle amount fluctuates with the price levels of the underlying index. They don’t pay interest. They produce exactly the index return minus the management fee, which is more than can be said for the Victoria Bay and Claymore ETFs. Investors get what they planned for in their asset allocation.

There is an important caveat. ETNs are debt obligations and are subject to the solvency of the issuer, Barclays. This author would far rather bet his money on the solvency of Barclays over the skill of portfolio managers at Victoria Bay or Claymore.

USO is the dominant volume oil play, but OIL is so far the more dependable oil play.

Full Disclosure: Author owns DJP

Comments

[ling_thio:]

Looking at this graph: stockcharts.com/charts...?$wtic,oil,uso
OIL and USO are both loosing terrible ground with $WTIC.

2007 Apr 23 11:35 AM

[QVM Group:]

Good observation. I have a follow-up article that will deal with that question. Hopefully, it will be posted soon.

2007 Apr 24 01:21 AM

[QVM Group:]

ling_thio --- my follow-up article is published now. you are correct that OIL and USO had nearly identical results throughout the past year. the reason I like OIL and do not like USO is that OIL properly disclosed their benchmark and USO did not. USO and OIL both tightly tracked the Goldman Sach Oil Total Return Index which is a futures approach that deviated substantially from the spot price. OIL said that would do that while USO said the would track spot prices and did not (maybe could not given their approach). USO was much more popular with many times the volume of OIL. From a liquidity perspective USO was the security of choice and they did a fine job of tracking the Goldman index -- it's just that they said they would do something else and that is troubling to me, and makes me want to look elsewhere for exposure to oil.

2007 Apr 24 07:45 AM

[H Man:]

You state "they (ETNs) produce exactly the index return minus the management fee." How do you explain the discrepancy in iPath Market Returns and the iPath Indicative Value over just about every time period? The return info is availabe on the ipathetn.com website.

2007 May 04 01:52 PM

[Raj Dhamodh...:]

Indicative value is determined by fund owner (barleys) using a simple formula based on the underlying index (in this case MSCI India Total returns Index). You can say that this is the intrinsic value of the security. Market returns are based on the bid/ask spread on that day. It is always possible that these two are very close but always not perfect match due to the demand or lack there of for the security that day.

Another item you would notice is that the indicative value for INP is trailing the Index performance by few basis points. This again is a reflection of the efficiency with which they are able to track the index. I am sure this complicated by the fact that the underlying market is overseas.
randv
randv.blogspot.com
Investing, Globalization, Personal Finance

2007 May 08 09:57 AM

[Raj Dhamodh...:]

hi H Man, another point that I did not mention in the reasons for lag (but you did) is the expenses.
randv
randv.blogspot.com
Investing, Globalization, Personal Finance

2007 May 09 12:11 AM

[QVM Group:]

Thank you for you comments in response to reader questions. Also, this product (OIL) may have temporary variances that last longer than most ETFs because the have a weekly option for creation units instead of daily.

2007 May 14 11:17 AM

[H Man:]

I was actually referring specifically to the DJP- the DJ-AIG commodities index. Year to date index performance vs the ETN is WAY off 4.41% vs 5.02%. Only 35 bps is because the management fee.

2007 May 17 10:11 AM

[QVM Group:]

If you can provide your data source, I can respond better to your concerns. My data source is:
ipathetn.com/pdf/DJAIG...
ipathetn.com/iPath-Dow...

Please note that the mangement fee is 75 bpt not 35 bpt.

The performance difference you cite is 61 bpt which is better than the contractual terms.

2007 May 17 11:40 AM

[H Man:]

The 35bp mangement fee is the prorated management fee since I was using a YTD figure. I've looked into this a little more and the is a price difference between the indicative value (DJP.IV) and market price (DJP). Barclay's guarantees the index return minus management fees for the indicative value NOT the market price. If you refer to your second link and the "returns" section you can see what I'm taking about: ytd (as of April 30) market price return is 5.06% vs 5.80% and 5.56% for the index and indicative value.

So you get the index minus the management fee only if you buy when the market price is the same as the indicative price.

The 61bps difference is for ONLY 5 1/2 months which would annualize to roughly to 130 bps which is above the contractural terms.

It would be nice if Barclays would show historical premuim/discount as they do with their ETFs (AGG for example).

2007 May 18 08:34 AM

[QVM Group:]

H Man, I'll pass your comments along to the people at Barclays.

2007 May 18 09:40 AM