As a new product, ETN has a very short history. However, it has been growing very rapidly. The ETN represents a nifty product structure that is gaining respect and funding in the market. By 18 July 2006, just one month after the launch of first two ETNs, GSP and DJP, GSP had attracted more than $40 million in assets, and DJP had pulled in more than $130 million for Barclays. Investments in iPath ETNs surpassed $2 billion by late April 2007.
In just over a year Barclays has gathered close to $3 billion in eight funds. Encouraged by the good performance of the ETNs launched by Barclays, other financial institutions have either launched their own products or are drawing plans to partake of the ETN space. We believe more ETNs will be launched to raise more equity for financial institutions. For the customers, the advantages such as tax-efficiency and good liquidity of ETNs will attract more investors to this innovative structured product. All of these imply that ETN is becoming more and more popular.
However, now the question is whether this trend is going to last long. Several industry gurus point to factors that may well dampen the initial euphoria surrounding this product of financial engineering. The lack of historical record – upon which to base their decision to make ETN a part of their portfolio or not – could be keep potential investors at bay.
More importantly, the issuing banks advertise tax-efficiency as ETNs USP. If the IRS rules in the issuers’ favor, the implications of which have been discussed at length in Chapter 3, ETN sales could explode. But what if the IRS delivers an unfavorable word-or never rules? A line of thought that is doing rounds is that even if the IRS delivers an unfavorable word-or never rules at all-the ETNs could still be enormously successful.
The reason is that ETNs provide efficient access to segments of the market that would otherwise be difficult for retail investors to reach. But how could we expect that the investors would still prefer ETNs to ETFs, or any of the multitudes of other structured products out in the market, if there is no tax-efficiency for ETNs. Drawing a comparison to ETFs, another structured product, which suffers from only market risk, ETNs face both counter party risk and market risk. ETNs, bereft of their tax advantage, may lose their shine in the eyes of an entire class of investors.
To conclude, ETNs have performed very well so far as a new kind of structured product with lower fees, better liquidity and tax-efficiency. However, both financial institutes and investors should keep an eye the status of the tax opinion from the IRS on ETNs while seeking ETNs as business or investment possibility.
Tuesday, June 2, 2009
Structure of ETNs
The returns of ETNs are linked to the performance of a market benchmark or strategy, less investor fees. Currently, there are four types of ETNs, Commodity ETNs, Emerging Market ETNs, Currency ETNs and Strategies ETNs available in the market. (Please refer to Appendix A for a list of available products in each category.)
As discussed previously, ETNs are debt notes. When held to maturity, the investor will receive a cash payment that is linked to the performance of the corresponding index during the period beginning on the trade date and ending at maturity, less investor fees. Typically, ETNs do not offer principal protection.
ETNs could also be liquidated before their maturity by trading them on the exchange or by redeeming a large block of securities directly to the issuing bank. The redemption is typically on a weekly basis and a redemption charge may apply, subjected to the procedures described in the relevant prospectus.
The investor fee is calculated cumulatively based on the yearly fee and the performance of the underlying index and increases each day based on the level of the index or currency exchange rate on that day. Because the investor fee reduces the amount of return at maturity or upon redemption, if the value of the underlying decreases or does not increase significantly, the investor may receive less than the principal amount of investment at maturity or upon redemption.
Since ETNs are unsecured, unsubordinated debts, they are not rated, but are backed by the credit of underwriting banks. Like other debt securities, ETNs do not have voting rights. But unlike other debt securities, interest will not be paid during the term of the most ETNs.
As discussed previously, ETNs are debt notes. When held to maturity, the investor will receive a cash payment that is linked to the performance of the corresponding index during the period beginning on the trade date and ending at maturity, less investor fees. Typically, ETNs do not offer principal protection.
ETNs could also be liquidated before their maturity by trading them on the exchange or by redeeming a large block of securities directly to the issuing bank. The redemption is typically on a weekly basis and a redemption charge may apply, subjected to the procedures described in the relevant prospectus.
The investor fee is calculated cumulatively based on the yearly fee and the performance of the underlying index and increases each day based on the level of the index or currency exchange rate on that day. Because the investor fee reduces the amount of return at maturity or upon redemption, if the value of the underlying decreases or does not increase significantly, the investor may receive less than the principal amount of investment at maturity or upon redemption.
Since ETNs are unsecured, unsubordinated debts, they are not rated, but are backed by the credit of underwriting banks. Like other debt securities, ETNs do not have voting rights. But unlike other debt securities, interest will not be paid during the term of the most ETNs.
Exchange-Traded Note ( ETN)
An exchange-traded note (or ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer.
ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Thus ETN has an additional risk compared to an ETF - upon any reduction of credit ratings or if the underwriting bank goes bankrupt, the value of the ETN will be eroded.
Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted. Similar to index fund, they are linked to the return of a benchmark index. But as debt securities, ETNs don't actually own anything they are tracking.
The first ETN, marketed as the iPath Exchange-Traded Notes, was issued by Barclays Bank PLC on 12 June 2006. This was soon followed by Bear Stearns, Goldman Sachs & Swedish Export Credit Corp. In 2008, additional issuers entered the market with their own offerings; these include BNP Paribas, Deutsche Bank, UBS, Lehman Brothers, Morgan Stanley and Credit Suisse. As of April 2008, there were 56 ETNs from nine issuers tracking different indexes.
The popularity of ETNs is mainly due to the advantages that it offers to investors.
ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Thus ETN has an additional risk compared to an ETF - upon any reduction of credit ratings or if the underwriting bank goes bankrupt, the value of the ETN will be eroded.
Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted. Similar to index fund, they are linked to the return of a benchmark index. But as debt securities, ETNs don't actually own anything they are tracking.
The first ETN, marketed as the iPath Exchange-Traded Notes, was issued by Barclays Bank PLC on 12 June 2006. This was soon followed by Bear Stearns, Goldman Sachs & Swedish Export Credit Corp. In 2008, additional issuers entered the market with their own offerings; these include BNP Paribas, Deutsche Bank, UBS, Lehman Brothers, Morgan Stanley and Credit Suisse. As of April 2008, there were 56 ETNs from nine issuers tracking different indexes.
The popularity of ETNs is mainly due to the advantages that it offers to investors.
Spread Trade
A spread trade refers to the act of buying one security or futures contract and selling another related one, in an attempt to profit from the change in the price difference between the two.
As expiry of a long contract and delivery of the underlying physical commodity approaches, spread trades are used by Index Speculators in commodity futures markets to "roll" their positions out to a later delivery month. Thus, "extinguishing" their open interest in the expiry month while creating new open interest in the later delivery month.
Because they always defer delivery, Index Speculators never take possession of physical inventories and do not operate in the commodity markets with concern for supply and demand- only price movement
Common examples are:
- Crack spread, between crude oil and gasoline
- Spark spread, between natural gas and electricity (for gas-fired power stations)
- Option spread, between the price of two option contracts on the same underlying stock or commodity
- Calendar spread, between the price of an option or commodity with different expiration/delivery dates.
The margin requirement for a futures spread trade is usually less than the sum of the margin requirements for the two individual futures contracts. Sometimes the margin requirement is even less than the requirement for one of the contracts.
Bid/Offer Spread
The bid/offer spread (also known as bid/ask spread) for securities (such as stock, futures contracts, options, or currency pairs) is the difference between the price quoted by a market maker for an immediate sale (bid) and an immediate purchase (ask). The size of the bid-offer spread in a given commodity is a measure of the liquidity of the market and the size of the transaction cost.
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread.
All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders.
On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders
The trader initiating the transaction is said to demand liquidity, and the other party (counterparty) to the transaction supplies liquidity. Liquidity demanders place market orders and liquidity suppliers place limit orders. For a round trip (a purchase and sale together) the liquidity demander pays the spread and the liquidity supplier earns the spread.
All limit orders outstanding at a given time (i.e., limit orders that have not been executed) are together called the Limit Order Book. In some markets such as NASDAQ, dealers supply liquidity. However, on most exchanges, such as the Australian Securities Exchange, there are no designated liquidity suppliers, and liquidity is supplied by other traders.
On these exchanges, and even on NASDAQ, institutions and individuals can supply liquidity by placing limit orders
Roll -- Yield
The roll yield is the yield that a futures investor captures when their futures contract converges (or rolls up) to the spot price in a backwardated futures market. The spot price can stay constant, but the investor will still earn returns from buying discounted futures contracts, which continuously roll up to the constant spot price.
For example, suppose the spot price of oil is $58 and the market is inverted because inventories are relatively low. This means the first futures price might be at $57 and the next contract at $56. You go long the front contract as described above. Now suppose a few weeks pass and nothing happens to the spot price.
The futures contract you own moves toward the spot price as delivery approaches, and we can assume the spread between the futures stays at a dollar. You sell your maturing futures near the $58 spot price and buy the next future for around $57.
Note that in an inverted market you make money from what is called "the roll yield" even if commodity prices remain unchanged.
For example, suppose the spot price of oil is $58 and the market is inverted because inventories are relatively low. This means the first futures price might be at $57 and the next contract at $56. You go long the front contract as described above. Now suppose a few weeks pass and nothing happens to the spot price.
The futures contract you own moves toward the spot price as delivery approaches, and we can assume the spread between the futures stays at a dollar. You sell your maturing futures near the $58 spot price and buy the next future for around $57.
Note that in an inverted market you make money from what is called "the roll yield" even if commodity prices remain unchanged.
Commodity Price Index
A commodity price index is a fixed Mandan weight index or (weighted) average of selected commodity prices, which may be spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.
The constituents in a commodity price index can be broadly grouped into the following categories:
- Energy
- Metals
- Base Metals
- Precious Metals
- Agriculture
- Grains
- Softs
- Livestock
Investors can choose to obtain a passive exposure to these commodity price indices through a total return swap. The advantages of a passive commodity index exposure include negative correlation with other asset classes such as equities and bonds, as well as protection against inflation.
The disadvantages include a negative roll yield due to contango in certain commodities, although this can be reduced by active management techniques, such as reducing the weights of certain constituents (e.g. precious and base metals) in the index.
Commodity
A commodity is something for which there is demand, but which is supplied without qualitative differentiation across a market. It is a product that is the same no matter who produces it, such as petroleum, notebook paper, or milk.
In other words, copper is copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereos, on the other hand, have many levels of quality. And, the better a stereo is [perceived to be], the more it will cost.
One of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. Well-established physical commodities have actively traded spot and derivative markets. Generally, these are basic resources and agricultural products such as iron ore, crude oil, coal, ethanol, salt, sugar, coffee beans, soybeans, aluminum, rice, wheat, gold and silver.
Commoditization occurs as a goods or services market loses differentiation across its supply base, often by the diffusion of the intellectual capital necessary to acquire or produce it efficiently. As such, goods that formerly carried premium margins for market participants have become commodities, such as generic pharmaceuticals and silicon chips.
In other words, copper is copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereos, on the other hand, have many levels of quality. And, the better a stereo is [perceived to be], the more it will cost.
One of the characteristics of a commodity good is that its price is determined as a function of its market as a whole. Well-established physical commodities have actively traded spot and derivative markets. Generally, these are basic resources and agricultural products such as iron ore, crude oil, coal, ethanol, salt, sugar, coffee beans, soybeans, aluminum, rice, wheat, gold and silver.
Commoditization occurs as a goods or services market loses differentiation across its supply base, often by the diffusion of the intellectual capital necessary to acquire or produce it efficiently. As such, goods that formerly carried premium margins for market participants have become commodities, such as generic pharmaceuticals and silicon chips.
Monday, June 1, 2009
ETNs access to Markets and Strategies
ETNs have provided access to hard-to-reach exposures, such as commodity futures and the Indian stock market. Certain asset classes and strategies are not easily accessible to individual investors.
For example, the “momentum investing” strategy, which is used in SPECTRUM Large Cap U.S. Sector Momentum Index, is to take advantage of the varied performances of the 10 sub-indexes of the S&P 500 Total Return IndexSM (SPTR) relative to each other and to the SPTR.
The weights of the 10 sub-indexes are computed each day based on performance and correlation. This makes SPECTRUM Large Cap U.S. Sector Momentum Index difficult to track through ETF. On the contrary, ETN provides opportunities to gain exposure to these types of investment strategies in a cost-efficient way.
For example, the “momentum investing” strategy, which is used in SPECTRUM Large Cap U.S. Sector Momentum Index, is to take advantage of the varied performances of the 10 sub-indexes of the S&P 500 Total Return IndexSM (SPTR) relative to each other and to the SPTR.
The weights of the 10 sub-indexes are computed each day based on performance and correlation. This makes SPECTRUM Large Cap U.S. Sector Momentum Index difficult to track through ETF. On the contrary, ETN provides opportunities to gain exposure to these types of investment strategies in a cost-efficient way.
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