An ETN Is Not a Kleenex

Jeremy Glaser: For Morningstar I'm Jeremy Glaser. I'm here today with Ben Johnson, he's our director of global ETF research and also the editor of Morningstar ETFInvestor newsletter. We're going to look at how not all ETFs are created equal.

Ben, thanks for joining me.

Ben Johnson: Glad to be here, Jeremy.

Glaser: Let's start by looking at why investors might need to look a little bit closer at an exchange-traded product before diving in. Why aren't all ETFs really just kind of a generic catchall?

Johnson: So, the "ETF" term gets thrown about, sometimes somewhat loosely. So ETFs, with $2 trillion in assets under management, have created a big brand for themselves, much the same way in the realm of facial tissue, Kleenex has created a big brand for itself. If you're ever looking for a facial tissue, odds are you are going to ask for a Kleenex, whether it's Kleenex branded or not. So what we see is similar issues in the realm of ETFs. ETFs that are actually exchange-traded funds (the F in ETF)--even those are created somewhat differently in certain cases. And then there are also a host of non-fund exchange-traded products or ETPs that oftentimes also will be loosely referred to as ETFs. It is absolutely critical to understand that not all exchange-traded products are created equal, and what these nuanced differences between different product types might mean for the end investor.

Glaser: Let's look at a recent example where that distinction became important, that was with IAU, which recently had to suspend shares for a while. Could you talk to us about why that fund got into those difficulties while some of its peers didn't?

Johnson: So the iShares Gold Trust ran into some issues in that we saw a surge in gold demand in the early weeks of this year, and the number of shares outstanding in IAU increased pretty dramatically, to the extent where the gold trust ran up against its quota of the number of shares it had permission to issue. Now, it had this quota in place because unlike a traditional 40 Act fund, IAU, the iShares Gold Trust, is a 33 Act fund. And it cannot issue new shares in response to investor demand on an ongoing basis. So having hit and exceeded this quota, iShares had to go back and ask for permission to issue incremental shares so as not to be sort of in a position where it had run afoul of this quota that had been handed down.

Glaser: So what was the impact on maybe existing investors in IAU because of the fact that they weren't able to issue new shares?

Johnson: So if you look at the price performance of IAU, the iShares Gold Trust relative to its closest competitor, the SPDR Gold Trust GLD, what you saw were some very minor and very temporary dislocations in terms of the relative price of those two. So those two on any given day should move in lockstep with one another, and one might expect because there was a suspension in new creations of shares of IAU that it could potentially trade at a premium relative to its peers, relative to what sort of an assessment of its net asset value might be. What we saw during the course of that trading day is that it actually traded with a fairly high degree of fidelity to anyone's assessment of its underlying value, which leads me to believe that this is something that iShares had telegraphed to the market-making community. They had let them know that this was an issue that was going to be resolved in short order, and as such the market makers, the ones out there quoting prices in IAU, were able to keep its price in line with its underlying net asset value. And then all told, what we've seen is that they subsequently have received permission to issue new shares. The net effect to the end investor is minimal at most.

Glaser: So that turned out not to be a big deal. How about exchange-traded notes versus exchange-traded funds? Those are popular in a lot of different areas of the market. Does that always work out the same where that difference is not a big deal?

Johnson: So notes get called Kleenex and they are certainly not Kleenex. So notes are not funds, notes effectively are an IOU that’s written by a bank, that says I owe you, the end investor, the performance of this index in exchange for a fee. And what we've seen over the years is a number of issues with the structure. First and foremost there are concerns with credit risk. So notes are effectively unsecured subordinated debt issued by a bank. So if that issuing bank were to go belly up, you'd be not last, but certainly far down the line behind a number of that bank's creditors to get your money back. Other issues we've seen pop up are things like path-dependent fees. So these are not static fees. These are fees whereby if the performance of a given strategy goes in one direction or another, you could actually wind up paying more than that headline fee to continue to achieve whatever that exposure is that note's promising you.

And the last issue, the issue we've seen pop up more recently, is an issue with the capacity of the bank that issues that promise to hedge its own risk, and when they run up against those limits what they'll oftentimes do is just call the bet off entirely. So we saw that with OIL [iPath S&P GSCI Crude Oil TR ETN] recently, which is one of the more popular notes offering exposure to underlying performance of oil futures. That bet ultimately got called in to the extent that there is a halt or a reduction in the issuance of new shares of that note. We saw a massive premium develop. So the price of that note at one point was trading almost 40% above its underlying net asset value that sets up for some potential nasty surprises for investors in those notes, which I need to emphasize and cannot emphasize enough, are not funds.

Glaser: Maybe that’s something to be more keenly aware of. Another popular fund that may be a little bit different than you might expect, is SPY [SPDR S&P 500 ETF]. Now this is a core holding for many people. How is this different from just kind of plain-vanilla ETF?

Johnson: So a perfect example of how not all ETFs funds are created equal is SPY, and SPY is structured relative to its close competitors the iShares S&P 500 ETF, IVV, as well as the Vanguard S&P 500 ETF, VOO. So SPY is the granddaddy of them all. It's the first ETF and it's still the biggest ETF today, and given its legacy it's built using a bit of an outdated structure. So it's a unit investment trust, and as such it cannot immediately reinvest dividends that it receives from its underlying stocks. It cannot lend out those stocks in exchange for a fee; there is no securities lending that takes place. Now what that means with respect to SPY's performance relative to IVV and VOO, which enjoy a more modern fund structure, is that it tends to lag that benchmark, the S&P 500 index, by a greater degree than IVV or VOO, precisely because it cannot immediately reinvest dividends, cannot lend out securities, and to boot it's got a fee that's modestly higher as well.

Glaser: So that could be a situation where maybe not a big problem to own it, but certainly some downsides there. 

Looking forward do you see any new developments, new types of structures that are coming out that you think are going to need some extra scrutiny and they are going to look different than a traditional ETF?

Johnson: So, the alphabet soup that is the exchange-traded product space has only got more letters coming into the broth, and most recently what we saw was the launch of the first ETMF the exchange-traded managed fund, which goes under the branding name of NextShares. This is a technology that was acquired by Eaton Vance and what ETMFs are, are essentially non-transparent exchange-traded products. So active managers are a bit sheepish about entering an ETF proper because it would require that they show their full portfolio on a daily basis. Clearly, many don't want to be the player at the poker table that has to show their hands to their tablemates every time they get a new card on the flop.

So the ETMF solves for this in that the portfolio disclosure cycle is identical to what you see within the context of traditional mutual funds. You also pick up some of the benefits that are traditionally associated with ETFs in the form of lower fees [and] the potential for greater tax efficiency. So ETMFs and other either nontransparent ETFs or other nontransparent exchange-traded product types that have yet to be approved by the SEC are only going to sort of further muddle these comparisons and create new challenges for investors who are trying to assess the different envelopes that these investment strategies are being delivered in.

Glaser: Sounds like the name of the game is still doing your research and knowing what you own.

Johnson: That's absolutely the case.

Glaser: Well, Ben, I certainly appreciate you joining me today.

Johnson: I'm glad to be here, Jeremy.

Glaser: For Morningstar I'm Jeremy Glaser. Thanks for watching.