The ETF observer: Deborah Fuhr
ETNs and ETCs are not the same as ETFs
Investors are very confused by the alphabet soup – ETFs, ETNs, ETCs, and ETPs – and are often not sufficiently aware of the distinctions between the different types to understand the variations in the structures from a regulatory counterparty and tax perspective. Investors in products bearing the “Exchange Traded” prefix almost invariably assume they have invested in funds.
We advocate that investors be advised to think about all exchange traded offerings under the generic term exchange traded exposures. Clearly then there is a need to distinguish between exchange traded funds (ETFs), which are structured and regulated as funds and all other exchange traded exposures. For the investor however, the point is that once they are made aware that their exposure is outside the highly regulated world of both their investment and their structural protections in the funds world they can understand the effectively unregulated nature of their investment and proceed with caution. Non-fund products should never use or be loosely associated with the term “ETF”.
It is worth reminding ourselves that for all the vigorous debate within the exchange traded funds community; we are talking about exposures within a highly regulated investment funds framework. While there may be concerns around the quality or liquidity of swap collateral or liquidity or the robustness of a securities lending programme, it is important not to lose sight of the fact that from an investor perspective, their investment is through a highly regulated entity and any and all exposures have strict parameters – and the investment itself is well protected in its fund wrapper.
While ETFs are structured and regulated as funds – such as in the United States, ETFs follow the 1940 Act regulations with some exemptions, and in Europe, ETFs are structured following the UCITS regulations – Exchange Traded Notes (ETNs) and Exchange Traded Commodities (ETCs) are typically not structured as nor regulated as funds.
Investments in non-fund structured Exchange Traded Products (ETPs) have effectively no regulation either of the investment exposure itself or the delivery mechanism of that exposure. The most common non-fund exposure is through a debt security. This structure may vary from a simple note programme issued by a bank where an investor has, in addition to his investment risk, 100% exposure to the issuing bank to more complex structures utilising special purpose vehicles and collateralisation programmes to ensure effective segregation of assets between different types of exposure – an automatic feature of fund structures – and elimination of counterparty risks. As unregulated structures however, it is incumbent on the investor to ensure he or she understands those risks and the mitigating factors the promoter introduces – or more pertinently does not introduce – to mitigate.
The most common ETN and ETC exposures are wrapped into a debt security, whose value is linked to the performance of designated investments. One type involves a senior, unsecured, unsubordinated note issued by a bank where an investor is not only exposed to an investment risk but also the ability of the issuing bank to stay afloat.
The other is cobbled together out of special purpose vehicles and collateralisation programmes. It sets out to segregate different types of exposure and eliminate counterparty risks. But because the structure is unregulated, it is up to investors to ensure they understand the risks and mitigating factors the promoter introduces – or fails to introduce – to mitigate any future loss.
Some significant differences between UCITS ETFs and ETNs are: the investor typically has 100% counterparty exposure to the issuing entity – so in the case of bankruptcy of the issuer the investor may not receive their full investment back. They have maturities that are typically 30 years from the date of issuance; fees for ETNs can be higher than ETFs; and fee disclosure for ETNs is not standardised, and often there are additional fees for transaction costs, hedging and index license costs on top of the annual investor fee. Like ETFs, leverage and inverse ETNs and ETCs performance will be impacted by the path dependency.
At the end of January 2013, the global ETF and ETP industry had 4,766 ETFs and ETPs, with 9,813 listings, assets of US$2.05 trillion, from 209 providers on 56 exchanges according the ETFGI Global ETF and ETP industry insights January 2013 monthly report. Globally, ETFs represent 70% of the universe of 4,776 of ETFs and ETPs and 90% of the US$2.05 trillion invested by assets. Most ETNs and ETCs are providing exposure to a commodity, a commodity benchmark, a currency, volatility or leverage or inverse commodity exposures. These are typically exposures, which are not possible to create as UCITS ETFs.
ETNs and ETCs work in a similar fashion to ETFs in terms of trading and settlement procedures but are very different in terms of their exposures, structural safeguards, regulatory and often tax treatment.
Far from an open market deal, the deals are struck in private. It is left to product providers to decide whether exposures are appropriate and fund protections are efficient. And investors shoulder the risk. Additional protections end up incurring additional costs, leaving the risk/reward analysis for the investor.
The term ETC is routinely used to reference notes backed by the underlying commodity or equivalent security. But it is also used to refer to credit-backed commodity notes, which may – or may not – be collateralised. If it does exist, the collateral may ultimately not be of sufficient quality, thus raising some of the systemic concerns supra national bodies have alluded to. Yet other variants use the term “ETC” to refer to Exchange Traded Currency products.
The utility of these instruments for the informed and experienced investor is not in question. But the near collapse of banking institutions has drawn attention to the risks inherent in exchange traded exposures. It is ironic that ETFs have been in the eye of the storm, while ETNs and ETCs put together by the banks have escaped regulatory scrutiny and adverse publicity that ETFs have been subjected to.
Regulators need to ensure this anomaly is addressed. The Financial Industry Regulatory Authority in the US announced in March 2012 it has a review underway looking at an array of issues surrounding ETNs and other complex products.
It could result in general regulation designed to ensure that inappropriate exposures or insufficiently robust delivery methods are not available to less sophisticated investors.
It is surprising that the need for education on unregulated ETNs and exchange traded commodities and currencies has not been afforded a higher priority.
We advocate that investors be advised to think about all exchange traded offerings under the generic term “Exchange Traded Exposures (ETEs)”. The benefit of such a term is that it does not, unlike some terms in loose usage, imply the nature of the product and more particularly its regulation.
Clearly then there is a need to distinguish between ETFs, which are structured and regulated as funds and all others as ETEs.