Blog - Investing Notes

May 28, 2009 - Characteristics of Exchange-Traded Notes

An exchange-traded note (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... Similar to equities, they are traded on an exchange and can be shorted. Similar to index funds, they are linked to the return of a benchmark index. But as debt securities, ETNs don't actually own anything they are tracking." Should investors consider ETNs as diversifying investments? In their May 2009 paper entitled "Exchange Traded Notes: An Introduction", Dean Diavatopoulos, James Felton and Colbrin Wright: (1) describe what ETNs are and why they might appeal to investors; (2) analyze the daily tracking error between the ETN market prices and the indicative (redemption) value; (3) investigate why tracking error varies; and, (4) test whether ETN tracking error predicts future price changes for assets associated with the ETN. Using data for various ETNs from inception (with the earliest in June 2006) through June 2008, they conclude that:

• ETNs offer investors easy and affordable long/short exposure to individual currencies and commodities and to diversified currency and commodity markets with known transaction costs and a fair amount of liquidity.
• On average, market prices of ETNs track very closely to indicative values, providing reasonable assurance that they will generate returns similar to those of associated assets.
• Changes in ETN tracking errors are significantly explained by market-wide (credit spread), but not issuer-specific, measures of default risk. There is little evidence of liquidity risk.
• Periods of extreme negative tracking error for a particular ETN tend to be followed by subsequent periods of unusually strong ETN indicative value increases. Results are strongest for abnormal tracking error over the previous 30 days and returns for indicative values over the subsequent 30 days (see the chart below). In other words, ETN tracking errors may be useful in predicting movements in the prices of the assets associated with the ETNs.
• Investors should understand that an ETN holding is a loan to the issuer with no securing collateral and that the issuer may use the proceeds for almost any business purpose.
• Hedging activities of ETN issuers may materially reduce the value of the ETNs (unfavorably move the markets of associated assets).
• It is still unclear how the IRS views most ETNs.

The following chart, taken from the paper, plots the average cumulative returns over 30 days to the indicative values of the 30% of ETNs with the most negative and the 30% of ETNs with the most positive past abnormal tracking errors. Groups are formed based on average abnormal tracking error over the previous 30 days. The group with past extremely negative (positive) tracking error produces a cumulative return of 4.65% (1.37%) over the subsequent 30-day period, suggesting that past ETN tracking errors may predict future returns for the associated assets.

In summary, ETNs offer investors easy access to alternative asset classes, but holding them is more like lending money to issuers than holding assets.

For related research, see Blog Synthesis: Investing/Trading in Commodities and Commodity Futures.