Since 1993, when the first U.S. ETF came to market, this industry has grown to 1,473 issues and $1.3 trillion. At the simplest level, the objective of an ETP is to track the performance of an index of equities, fixed-income securities, commodities, or currencies as closely as possible. However, how each ETP structure achieves that goal can be drastically different.
The primary asset management consideration is whether an ETP fully replicates or optimizes its benchmark's constituents. ETPs that track indices with highly liquid securities often choose to fully replicate the benchmark by holding each constituent in the exact weighting of the index in order to minimize tracking differences.
The S&P 500 Index is an example of a benchmark that is often fully replicated, and any tracking difference is attributed to the ETP's operating expenses.
SPDR S&P 500 ETF Trust (SPY) is an example of an ETF that uses full replication.
Other ETPs track indices whose components are more difficult or costly to trade. The lack of liquidity, narrow market focus, large number of holdings, and high transaction costs are reasons for optimizing a portfolio rather than fully replicating it. These funds invest in a limited number of the benchmark's securities by using an optimizing sampling technique to represent the performance characteristics of the index. While optimization can decrease a fund's transaction costs, it can also increase the tracking difference.
Exchange-traded notes (ETNs) are a special ETP structure in which the fund doesn't own any of the underlying securities of the benchmark but instead is a senior unsecured debt obligation of a bank that is linked to the exact performance of the market index, less investor fees. ETNs provide investors low tracking differences. However, because ETNs don't buy and hold assets to replicate or approximate the underlying index, they introduce counterparty risk/credit risk into the equation.
With other ETPs, if an issuer has solvency problems, the underlying securities are available to the investor. With ETNs the investor could end up standing in line with the firm's other general creditors. If the issuer defaults on the note, investors may lose some or all of their money.
With the ongoing credit crisis in Europe, it would be smart for ETN investors to keep an eye on the issuer's credit rating. A more practical solution to real-time ratings that was put forth by Index Universe is to keep an eye on the issuing firm's credit default swap (CDS) rates. A historical look at the one-year CDS rates for all ETN issuers could be quite telling.
In recent months we witnessed some troubles with ETNs that are worth mentioning. In late March 2012, two ETNs, one issued by Barclays and another issued by Credit Suisse, experienced huge price movements up and then down after the financial issuers of the notes changed their willingness to engage in market-making for the ETNs in question.
This led to a supply-and-demand issue that impacted the price of the ETNs, even though the underlying index had not changed significantly.
In a resulting FINRA investor alert it was proposed that before trading in the secondary market, investors should compare an ETN's closing and intraday indicative values (IIV) with the market price. If the ETN is trading at a significant premium to its closing value or IIV, investors should consider another product. They should ask if the issuer has suspended the note, and if so why.
For investors in taxable accounts, the structure of the ETP can have a significant impact on total returns.
Open-end ETFs and UIT ETFs have tax attributes very similar to conventional funds. Income distributions and dividends must be passed through to the investor each year, along with any realized short- or long-term capital gains.
Both structures provide the benefit of in-kind redemptions, eliminating most of the capital gains, although there are still situations that may cause realization of capital gains, such as exceeding the diversification rule under the 1940 Act. Most ETNs, on the other hand, provide a little more tax efficiency than the other structures because the IRS views them as prepaid contracts, which are not subject to taxation until liquidation of the position.
Most ETNs do not pay out any sort of interest payment or dividend distribution, which means there is no annual tax. When the investor sells the ETN or it matures, the standard short- and long-term capital gains rates apply. For currency ETNs, however, the IRS is not as liberal with its rulings. For currency ETNs all capital gains, regardless of the holding period, are treated as ordinary income and are taxed at the investor's highest marginal tax rate.