The Differences among ETFs, ETNs and ETCs, and their Advantages and Disadvantages
ETCs and ETNs provide investors the niche market or alternative strategies that otherwise wouldn’t be available under ETF structure, with low tracking error and tax advantages. However, both are subject to the disadvantage of higher credit risks and less investors protection.
Why do we need ETCs and ETNs, in addition to ETFs?
The term ‘Exchange Traded Product’ (ETP) is a broad umbrella which covers a number of different investment vehicles including ETFs (Exchange Traded Funds), ETCs (Exchange Traded Commodities or Currencies) and ETNs (Exchange Traded Notes).
ETFs, like a traditional open-end fund, owning a share in an ETF gives investor a proportional equity stake in a trust that holds the underlying stocks, bonds or derivatives. Traditionally, ETFs is primarily used for providing exposures to stock and bond portfolios. However, to tap into alternative assets class, such as commodities or currencies, it hits two constrains.
- First is the diversification requirement, where ETFs complied with UCITS framework has to ensure no single issuer has allocation over 10% and the total allocation of issuers with over 5% allocation has to be less than 40%, thoughts the actual rules is quite involving, with many waivers. Similar rules in US exist in 1940 Act. For Commodity or Currency funds, which hold single commodity like gold, a currency pair, or a group of commodities in energy sector including crude oil, gasoline, natural gas, etc., a lack of sufficient diversification of the underlying assets prohibit the use of mutual fund structure.
- Second is restriction on assets types, where the underlying securities that the fund holds fall out of the UCITS scope of eligible assets. In the case of commodity, currency or structured products, the investible securities are forward, futures or swaps, instead of stocks or bonds.
As a result, all non UCITS funds fall under the scope of Alternative Investment Fund Managers Directive (AIFMD) in Europe, marketed as ETCs or ETNs. ETFEurope.net covers more than 2,000 European ETFs, 600 ETCs and about 200 ETNs.
Chart 1. The Distribution of European ETFs, ETCs and ETNs
What are ETCs?
ETCs are designed to gain exposure to an individual commodity, a basket of commodities or currency pairs. Commodity ETCs are structured in two ways — physically or synthetically.
- Physical Commodity ETCs are backed by a specific quantity of a commodity, gold for example, and aim to provide exposure to commodity spot price.
- Synthetic Commodity ETCs uses derivatives including futures, Brent crude oil for example, or forward contracts to track the performance of commodity indices.
- Currency ETCs are used to offer investors access to currency pairs or currency baskets. Currency ETCs typically track forward indices, which are constructed to simulate a continuous exposure to currency forwards returns.
ETCs is non-interest bearing debt securities. Unlike ETNs, ETCs are fully collateralised.
- ETCs that track the price of physical metal and are backed by an entitlement to allocated metal held with a custodian.
- ETCs that using futures contracts to tracks the return of commodity or currency indices are backed by fully funded futures positions. Cash or security collaterals are posted against the daily outstanding exposure held with a collateral custodian.
What are ETNs?
Instead of holding underlying securities like ETFs, ETNs are generally issued by banks and hold no assets. An issuer bank promises to pay a specified sum — the return of the underlying index minus expenses. ETNs usually do not pay out an annual coupon or dividend.
ETNs holds no assets and are not collateralised, it operate simply on issue’s promise of delivering returns that track the underlying index, meaning ETNs are entirely reliant on the creditworthiness of issuing entities.
By moving to an ETN structure, banks or issuers eliminated the costs associated with holding commodities, currencies, and futures and improved the tax structure for investors.
To search Commodity, Currency, and Leverage and Inverse Leveraged ETCs/ETNs on ETFEurope.net.
The Differences between ETFs, ETCs and ETNs
Advantages of ETCs and ETNs
Market Access:
ETCs/ETNs are created for niche market,( e.g. commodity, currencies) or alternative strategies, (e.g. leveraged, inverse leveraged) otherwise wouldn’t be available under traditional ETF structure.
Low Tracking Error:
The difference between the portfolio’s return and the value of the index is called the tracking error. In theory, all ETPs (including ETFs, ETCs, and ETNs) should delivery index return minus expense ratios. However, in the case of ETF, the tracking error can be significant. ETFs’ fund manager has the discretion to adopt, for example, sampling — aiming to optimise or reduce the number of holdings in the index, or security lending — aim to boost ETF returns, therefore the ETF’s tracking error can be more than just index return minus expense ratios
However, ETCs not involve any active or discretionary management, and there is no investment policy. For physically backed ETCs, Investors has a fixed entitlement to physical assets less management fees; for futures backed ETCs, the price is equal to the value of the underlying index less a daily management fee, therefore the tracking error is small.
In the case of ETNs where issuer promises to pay the full value of the index minus the expense ratio, no matter what, it completely eliminates tracking error.
Tax advantage:
Both ETCs and ETNs are non-interest bearing debt instrument. Any accrued interest or dividend, and any appreciation in the value of the index, are generally rolled into the value of the ETFs, so investors don’t incur tax liability until the time of sale.
Disadvantages of ETCs and ETNs
Credit Risk:
Investors in ETNs becomes unsecured creditors of the swap providers, banks, therefore need to take into account credit risk of the swap providers. Credit exposure in ETCs is mitigated by posting collateral (assets) against the underlying holdings.
Less Investors Protection
ETCs/ETNs are debt instrument, not investment companies. They are not regulated under the UCITS in Europe or 1940 Act in US, and lack many of the investor protection compared to an investment company. In the event of market disruption where ETPs cannot be sold in the secondary market, ETCs and ETNs don’t ensure the possibility of direct redemption/sell with issuers in the primary market.
