Our guide to exchange traded notes

Barclays Capital’s Nathan Bance explains how exchanged traded notes differ from other products in their family.

The fledging European market for exchange traded notes (ETNs) has been growing steadily, with more than $4.2bn in assets under management by the end of June 2011, according to BlackRock.

However, despite sitting firmly within the burgeoning exchange traded product (ETP) family, there remains a lack of clarity both about how ETNs differ from their counterparts – exchange traded funds (ETFs) and exchange traded commodities (ETCs) – and how ETNs can be used within investor portfolios.

Family resemblance

First, the similarities. Like ETFs and ETCs, ETNs provide exposure to a specific underlying or index, theoretically with as wide an investment universe as the former.

They can also, as you would expect with any ETP, be bought and sold like a stock. Importantly, however, ETNs are purely debt instruments: senior, unsecured, unsubordinated notes issued by underwriting banks.

This is significant for a number of reasons, not least in terms of transparency and cost. As debt securities, ETNs usually have a single counterparty – the issuing bank – which means investors are exposed to the credit risk of one, clearly identified institution.

In contrast, other exchange traded products such as ETFs are usually collateralised physically by an underlying portfolio of securities, or synthetically through swaps.

As has been highlighted in the press in recent months, this collateral can be illiquid (and sometimes of poor quality), while synthetically collateralised ETFs also carry additional risk by being exposed to various swap counterparties.

What is perhaps less well known is that collateralised exchange-traded products can also carry extra costs such as administration, swap or custodian fees.

ETNs, on the other hand, have an all-inclusive annual management charge (investor fee). Due to the fact ETNs are uncollateralised, investors will only pay this published investor fee, while for other ETPs additional costs might distort the product’s performance.

As well as the transparency and risk benefits, ETNs are also liquid and efficient. For the most part, in addition to being freely transferable and exchange-listed, ETNs also have low denominations, with the minimum exchange trade being one unit.

Moreover, many have a daily puttable feature which means they can be sold back to the issuing bank at the behest of the holder, subject to minimum redemption amounts.

Why buy an ETN?

From an investment perspective, ETNs typically offer exposure to hard to access asset classes and strategies. Investors can, therefore, gain low-cost exposure to specific or broad commodity markets, such as precious metals, grain or energy.