The argument for using exchange-traded notes [ETNs] to access the commodities market gets stronger every day.
Barclays Bank has changed the policy on its iPath ETNs (DJP) to allow daily redemptions at net asset value [NAV], rather than weekly, as was originally the case. Barclays Managing Director and Head of Investor Solutions, Americas, Philippe El-Asmar, says the firm had originally thought a weekly redemption schedule was reasonable to allow the ETN market to develop and that the conversion to daily redemptions demonstrates Barclays' commitment to the success of its ETNs.
"We wanted to make the ETNs even more attractive to investors and to give investors better liquidity and also better transparency with regard to the frequency of creations—and to make ETNs as close as possible to ETFs. ETFs have daily creation and redemptions, and now ETNs have the same feature as well," El-Asmar adds.
ETNs trade like ETFs, but are actually debt instruments. The notes promise to deliver the exact return of an index, minus fees. Their biggest advantage, however, comes in the tax department. A traditional commodities futures mutual fund or exchange-traded fund [ETF] suffers two tax insults:
a) Any interest income the fund earns is paid out and taxed as regular income, with rates up to 35%.
b) The fund must be "marked-to-market" at year end, which means that the IRS treats the fund as if you sold it on December 31. If the fund is up for the year, you book a capital gain, which is taxed 60% as a long-term gain and 40% as a short-term gain.
Under the prevailing consensus, however, ETNs dodge this tax bullet. All gains—interest income and capital gains—are bundled into the value of the ETN, and investors don't owe any taxes until they sell. And when they do sell, if they've held the fund for more than a year, all gains are taxed as long-term capital gains, with a maximum tax rate of 15%. (There is some uncertainty as to whether the IRS will allow this tax treatment, but for now, they do.)
The biggest issue with ETNs, aside from the tax risk, is that they debt instruments, and therefore, they come with credit risk: If Barclays Bank were to implode, holders of the iPath ETNs would lose out: They would be forced to join the line of creditors looking to recoup pennies on the dollar for their investment.
By moving to daily redemptions, however, Barclays significantly shortens the window of credit exposure for large investors. Now, an investor holding 50,000 shares of an ETN is guaranteed that they can exit the fund—at NAV—at the close of trading on any day of the week.
"For any investor, the primary concern when buying an ETN is the credit exposure to the issuer," El-Asmar says. "By moving the creations and redemptions from weekly to daily, the buyer of an ETN can get out overnight, and so they've reduced their credit exposure to a daily exposure to the issuer versus a weekly exposure to the issuer."
The daily liquidity should also help arbitrageurs keep the ETNs closely priced to their NAV on an intraday basis.
"Instead of having a one-day-a-week window, it's a daily window. It allows those investors eliminating the premium or discount—arbitrageurs—to capture that spread overnight because they are capable of trading one day and then getting out the next, whereas before they could only create or redeem on a weekly basis," El-Asmar adds.
The story gets more and more interesting each day.