For ETN investors

For ETN investors, the results may come as a shock. The cost of insuring against major investment banks’ nonperformance—the cost of hedging out the risk that the ETN or ETC provider may go bust—has soared over the last year, reaching several percentage points per annum in some cases. See the chart below, courtesy of Credit Derivatives Research LLC, which shows the average five-year CDS spread in basis points for 15 major banks, both US and European.

After peaking near 2.5% following the Bear Stearns debacle, the cost to insure receded a bit. But as of mid-July, it was still well above 1.5%.

Of course, different banks carry different risks, and it pays to look at the specific underwriter for a specific ETN. But suffice it to say that these represent real (and large) costs, which should be added back to the total expense ratio when evaluating an ETN.

Now of course one advantage of ETNs is that they offer the ability to track areas of the market where physically holding the underlying asset may be difficult or expensive—commodities, for example—so this must also be taken into account. But no comparison of ETNs to ETFs should omit the question of issuer risk for the former, and how much it costs to insure against the counterparty’s nonperformance.


What about the swap-based ETCs from ETF Securities, which are backed by third-party contracts? Again, we should check how much it would cost to remove the performance risk of Shell Treasury, or AIG, depending on which ETC we’re looking at.

I’ve been unable to track down CDS spread data for Shell, but the spread chart of AIG is given below, with data from the beginning of last year. The cost of insuring against default by the US insurance company has surged by 25 times—from 10 basis points to 2.5 percent per annum—since January last year. Again, this must be regarded as a hidden “cost” of investing via the ETC—since, if an investor wanted to remove this counterparty risk, this is what they would have to pay to do so—and its magnitude dwarfs that of the costs discussed earlier in this article.

Now this may not be the end of the story—there could well be other, offsetting considerations for an investor, such as the difficulty in obtaining commodity exposure (especially to those raw materials incurring large storage costs) by other means. But the counterparty risk component of the AIG-guaranteed ETCs has jumped hugely over the last year, making the true cost to an investor substantially higher than the total expense ratio alone.

Unfortunately, most financial market product design continues to rely on ratings from the main credit rating agencies, which have proved almost useless in predicting many recent events of credit distress, and which have fallen into disrepute. Perhaps the next generation of exchange-traded products will pay more attention to what the credit derivatives market is telling us, or at least offer investors a way of hedging such counterparty exposures.

So my brief survey of costs has suggested that the largest one in some tracking instruments is one that is hardly mentioned by financial institutions—counterparty risk. The advent of the credit derivatives market has made it relatively easy to quantify, and no comparison between the ETFs, ETNs and ETCs should ignore it.

1. “Selecting the right ETF – not just a question of cost,” iShares monthly, July 2008.

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