Low-cost portfolios

Just when most financial advisors have become familiar with exchanged-trade funds (ETFs), they will have to master a new nomenclature. ETFs are now part of a category of what is known as “exchange-traded products” (ETPs). This broader label reflects the growth in the number of exchange-traded notes (ETNs) being traded globally.

ETNs share certain qualities with ETFs. The latter offer intraday liquidity and can be sold short. They also provide access to returns based on various market indices.

However, ETNs are fundamentally different to ETFs in their structure. ETNs represent unsecured debt obligations of an issuing financial services institution and simply track an index – as opposed to owning the underlying assets, like an ETF. An ETN has a maturity date, which is when the issuer will pay the holder an amount equivalent to the original issue value plus (or minus, if there’s a loss) the index return over the term of the note, less management fees.

The advantage of ETNs is that, fees aside, there is no tracking error because the payment at maturity is based on the exact performance of the index. ETNs also provide retail clients with efficient access to less accessible markets, leveraged strategies or more esoteric indices, such as the Chicago Board Options Exchange’s volatility index, which measures U.S. stock market volatility.

ETNs’ major drawback? They have credit risk because payment is ultimately dependent on the financial capability of the issuer. Also, liquidity can be an issue for thinly traded ETNs, and taxes and call features are complicating factors.

In Canada, there are only three ETNs available, all iPath Exchange Traded Notes issued by Barclays Bank PLC.

In the U.S., there is a much broader availability of ETNs, providing exposure to a range of commodity indices, various stock market indices (both long and short), and currency and fixed-income indices.

Meanwhile, ETFs continue to evolve. In the fixed-income arena, ETFs are moving beyond simply providing exposure to a broad index or a specific part of the debt and/or maturity spectrum. Toronto-based First Asset Investment Management Inc. has launched several ETFs that employ a “barbell” strategy, which allocates portions of the portfolio equally between short- and long-term maturities. Typically associated with active investment management, barbell strategies tend to work best in a flattening interest rate environment.

On the equities side, ETFs offer an increasing number of factor-based strategies. The better known are designed around size (micro, small, mid, large and mega) and value vs growth. However, ETFs focused on low-volatility stocks, which offer historical risk-adjusted outperformance and cover the major geographical markets, are now available.

Newer ETFs, designed to replicate more complex indices, are blurring the line between active and passive investing.

Virtually any rules-based investment strategy now lends itself to replication in the ETP world. For advisors building low-cost portfolios for their clients, the opportunities for customization just keep expanding.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own securities mentioned in this article.