Kevin Rich on Commodity ETFs and ETNs

| About: PowerShares DB (DBC)

As the head of Deutsche Bank's Currencies and Commodity ETF effort, Kevin Rich has been at the forefront of efforts to make exchange-traded commodity products available to all investors.The PowerShares DB Commodity ETF (NYSEARCA:DBC) was the first in the U.S., and is still one of the largest broad-based commodity ETFs in the world.

Recently, Deutsche Bank has added a new innovation to its lineup: commodity ETNs that offer leveraged and short exposure to the commodities market. Rich spoke with the editors of HAI about the new products. [HAI]: What drove the decision to launch ETNs?

Kevin Rich [Rich]: We've been developing exchange-traded funds for a number of years, and we know that people love ETFs for a few basic reasons: They are very transparent, they trade close to their net asset values and they offer exposure to important parts of the market.

When we saw ETNs come to market, we wanted to see if they would share those same features, and they did. ETNs have traded with tight bid/offer spreads in the intraday market, and investors are finding them useful. So we started looking at ETNs linked to variations of the same index our ETFs track, the Deutsche Bank Liquid Commodity Index.

HAI: How should an investor choose between an ETF and an ETN?

Rich: Investors should first consider which asset class they would like to access. The question of ETF versus ETN is similar to the question of ETF versus mutual fund. It's a question I hear all the time, but it's not the most important question investors should ask.

From there, investors can look at the index used to access that asset class. Not all indexes are created equal. That's especially true in commodities, given the issue of roll yield and contract selection. We believe that DBC and its optimized rolling strategy offer the best return, but the choice of one commodity index over another is an important choice either way. Once they've answered these basic questions, then investors can think about which vehicle is best for their needs.

HAI: So what are the advantages and disadvantages?

Rich: One advantage that ETNs have over ETFs is that there is no tracking error. A number of ETFs have large tracking error.

There may also be tax differences - for instance, some people don't like getting K-1s for tax purposes, and certain commodity ETFs give out K1s. All ETNs have 1099 reporting.

On the other side, where ETFs have an advantage over ETNs is that ETNs come with credit risk from the issuer. If the bank issuing the ETN defaults, that's a problem.

Part of the reason that Deutsche Bank offers both ETFs and ETNs is that both products offer good features for investors, and each investor has their own set of criteria. Some people couldn't care less about credit risk because they will monitor their ETN investments closely, they know there is a liquid intraday market and they know they can get out of the position any day they want. Other people care deeply about credit risk, and for those people, ETFs are a better choice.

HAI: Who is using ETNs vs. the ETFs?

Rich: So far, there's been a little bit more trading volume in the ETNs vs. the ETFs on a relative basis; a little bit more in-and-out. But it's too early to tell.

HAI: Why leveraged funds?

Rich: The decision to launch leveraged and inverse products was based on investor feedback. Plus, people clearly are using leveraged and inverse products in the equity markets, and there is good reason to expect that to carry over into commodities.

With inverse in particular, we know that not everyone is a commodity bull. A lot of people get bearish from time to time, and people were asking for the ability to take an inverse view on the commodities market.

Using an inverse ETN or ETF is a lot easier than shorting a traditional ETF. To short, you have to have a margin account; you have to locate the shares, which are often difficult to borrow; and you can always have your borrowed shares recalled, which could force you to close out the short position.

Shorting is more difficult than going long, and our thought process was that you could go long a product and capture the short return, making it easier to move that way in the market.

HAI: How are people using the leveraged products?

Rich: I think if you look at the equity leveraged products, those have a lot of institutional usage, and we expect some of that in our commodity products as well.

But I also think there are uses of leverage that people haven't caught on to yet. Instead of gaining double exposure, you can also think about gaining the same exposure while cutting your capital allocation in half. Instead of having $100 long a delta-one gold product, you could have 50% exposure on a leveraged basis. We anticipate seeing some of that activity long term, and that money will be more buy-and-hold type money.

HAI: The issue of long-term leverage exposure is complicated by compounding. The ProShares leveraged equity ETFs, for instance, have tended to return closer to 160% of the underlying index over the long term, rather than 200%.

One difference between your leveraged ETNs and the leverage equity ETFs is that you promise to deliver 200% of the monthly return while the ProShares ETFs track 200% of the daily return. Why did you make that decision?

Rich: The reason we reset the products at all is to keep leverage in line with the 200% goal. As you mention, the effect of compounding means that once the product moves, the leverage changes from the 200% mark until it's reset again. Also, if the product is never reset, you could eventually see either the long or the short side going down to a zero value. The reset significantly lowers the probability of ever going to zero.

As we developed the ETNs, we analyzed the historical data and found that resetting monthly keeps things close to the long-term 200% return we desire. At the same time, it requires less activity than resetting on the daily basis, which makes hedging easier.

The feedback around the implementation has been positive.

HAI: How will the new ETNs impact your relationship with PowerShares, which is the marketer of your commodity ETFs?

Rich: We recently reached an agreement with PowerShares whereby the ETNs will be rebranded the PowerShares DB ETNs, just like our ETFs. PowerShares will play the same role for the notes that they do for our ETFs, which is to create market awareness and show financial advisors how their customers can benefit from using the funds in their portfolios. As far as managing the risks and the products, however, that will remain Deutsche Bank's responsibility.

We think PowerShares does a great job working with advisors and with investor education. Marketing the ETF is just as important as creating a good product.

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