Schwab’s new ETFs solve one critical problem in the ETF market, but they won’t take over the world. At least not for a while.

I’ve been thinking about the Schwab ETF launch all week, trying to figure out if it’s a game-changing event or an overblown bit of marketing. I think it’s a bit of both.

The big news, of course, is that Schwab is entering the ETF market and breaking new ground on fees. It has launched four ETFs that offer the lowest expense ratios in the world: As low as 0.08 percent for U.S. broad market exposure. The new Schwab Total Market ETF (NYSEArca: SCHB) and Schwab Large Cap Equity ETF (NYSEArca: SCHX) are now the lowest-cost mutual funds available to retail investors.

What’s more, Schwab is offering zero commissions for Schwab customers who buy or sell the ETFs.

That’s a big deal. Commissions are a huge hurdle for retail investors looking to allocate to ETFs. A retail investor placing $1,000 at a time should think carefully before buying ETFs: Even low commissions of $10/trade can eat up returns. A $10 commission on a $1,000 purchase is equivalent to paying a 1 percent load. For most investors, that cost can overwhelm the advantages ETFs offer in terms of low expense ratios and tax efficiency.

I’ve been writing about the importance of eliminating this commission hurdle for years, and I applaud Schwab for doing it.

(Of course, Schwab isn’t the first to eliminate commissions: Zecco offers zero commission trading, and both Wells Fargo and Bank of America will let you trade for free if you keep $25,000 in their money market funds. But Schwab is a well-established brand with a huge client base and a built-in distribution system. For it to offer zero commission trading with no major “catch” is a big deal.)

So it’s with a bit of hesitation that I say that, at least out of the gate, I do not expect these ETFs to gain a huge amount of assets.

We’ve seen firms like Fidelity and E*Trade try to swoop into the indexing world before with ultra-low-cost mutual funds, only to fail. I’m not sure retail investors brook much difference between expense ratios of 8 basis points and 10 basis points. At a certain point, for retail investors, you end up talking small numbers.

Those differences in expense ratios can be overwhelmed by factors like how well the funds track their benchmarks and whether the sponsoring firms arrogate securities-lending revenues on the portfolios. Schwab does have the skills to run excellent index funds, but it will have to prove itself as an operator of these ETFs for a while before people buy in en masse.

For larger investors, the critical question is how these funds will trade.

There will be huge swaths of ETF investors who will not go near these funds until they’ve established a large asset base and can provide the kind of limitless instant liquidity offered by funds like the S&P 500 (NYSEArca: SPY): Hedge funds, other mutual funds, day traders and the like will be willing to pay commissions to ensure access to the deep pools of liquidity these funds provide. So far, the Schwab ETFs have been trading at decent spreads. But larger investors may still be concerned about the costs and time involved in moving large block trades near fair value. There are ways to do it with any ETF, but it will be harder in SCHX than it is in SPY for some time.

At least initially, Schwab ETF assets will be driven more by long-term buy-and-hold investors. It’s ironic given that the funds’ key selling point is “free trading,” but I think that’s true. And the simple truth is that buy-and-hold assets grow slower than fast-money trading assets. So look for a slow build on the Schwab ETFs rather than any runaway asset train.

There is one thing, however, that’s for certain: Schwab’s huge push to market these ETFs to its clients and to the retail investing public will drive increased awareness of the ETFs in general. In that sense, I think the Schwab ETFs absolutely will help drive the next major leap in growth for the ETF assets.

And over time, I expect the Schwab funds will gain significant assets. It just won’t happen overnight.

It’s one thing to love a product for its innovation, but another to blanket the world with that love without highlighting the real problems.

Paul did a great job covering the credit risk, although I tend to side more with Matt on that part of the argument. But my real problem with ETNs is trading them.

We can argue about chicken/egg all you like, but the reality is this: The very most interesting ETNs, the ones that would be tough to deliver in an ETF package, are the ones with the worst trading problems. Right now, the top of the league table in “holy cow, look at the spreads” is dominated by ETNs.

The reasons for this are simple: While it’s true that an Authorized Participant can roll up 50,000 shares of any ETN (at least the iPath ETNs) and turn those in for cash at NAV, that AP has to go get those shares from somewhere. When the trading volume plummets, that means it’ll be tough to get on the open market. To make matters worse, most of the fun ETNs are interesting precisely because their underlying markets (individual industrial metals, carbon credits, emerging market currencies, etc.) are difficult to get at.

The real reason these products trade so poorly is that they are truly forgotten. I don’t care how much you love them, Matt; when you can’t even find the documents for the Barclays GEMS Index ETN (NYSEArca: JEM) anymore (unless you go hunting at the SEC), how are investors supposed to have any confidence? There’s no arb mechanism in place to keep JEM near its index value, because nobody in their right mind is going to put on a 15-way currency forward contract in order to offset the risk of handing someone their ETN shares. Instead, JEM will simply trade all over the place until it finally, blissfully expires in 2038, or until Barclays Capital decides to put it out of its misery.

And this is a product that was launched just 20 months ago. Let’s be clear: With the note issued, and the full value of that note presumably hedged on a ledger somewhere in London, there is zero incentive for Barclays to ever pay attention to JEM again. Instead, they can just happily collect their 89 basis points until it trades itself into the ground. With just over $3 million left in the notes, that’s not much money―about $30,000 by my HP 12c. But that may be more money than it would cost in lawyers’ fees to actually shut the thing down.

I don’t mean to pick on Barclays―every issuer has their great products and their forgotten ones. I could make the same case for virtually all the ETN issuers. With most ETF products (with a few notable exceptions in illiquid asset classes), investors can be reasonably sure that if they exercise some basic common sense, they can get in and out of smaller ETFs, because the arbitrage mechanism for even the craziest one-off U.S. equity idea will still work.

These particular forgotten stepchildren, though, are land mines for the unwary.

In his latest blog, Matt sings the praises of ETNs and argues that the risk of losing money is “vanishingly small”.

Matt’s argument is that “most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath ETNs) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.”

In other words, even if you become concerned about the credit risk of the issuer and there is insufficient liquidity in the secondary market for you to trade, you can get out of a position by selling it back to the ETN issuer.

I agree with Matt that the tax treatment of ETNs gives them a huge advantage for US investors (ETNs are taxed at long-term capital gains tax rates and only on a deferred basis when sold, rather than annually like ETFs). ETNs also offer superior tracking ability since the issuer bank guarantees to pay you the relevant index return.

It’s also undoubtedly true that the credit risk component in banks’ unsecured debt (of which ETNs are a part) has dropped substantially this year, as can be easily seen by plotting a chart of credit spreads or from a glance at the counterparty risk index, so the market is telling investors that the risks of ETNs are nowhere near as large as they were (less than a third the levels of February this year, in fact, if you look at an average of issuers’ CDS spreads).

All the same, I’m a little uneasy about his argument.

Matt’s reassurance that you can put back an ETN holding to the issuer within two days, giving you time to get out if there are problems, sounds fine in theory but may not offer you full protection in practice.

There was a fascinating article yesterday on Bloomberg in which reporters Richard Teitelbaum and Hugh Son tell us that during the summer months of last year, AIG was trying to write down – by up to 40% – the value of credit default swaps it had written to banks.

The central thrust of the Bloomberg article is that the Fed, which paid out AIG’s unsecured creditors at par, was more generous than it needed to be by paying out counterparties in full rather than enforcing a “haircut”.

The reporters quote Janet Tavakoli, a credit market specialist, as saying, “There’s no way they should have paid at par. AIG was basically bankrupt.” As an example of a haircut being applied in similar circumstances, the article cites a case involving Citigroup Inc., which last year agreed to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a US$1.4 billion CDO.

What’s the relevance of all this to ETNs? Well, the whole question of whether unsecured bank creditors (such as ETN holders) should be protected by the authorities or forced to accept some cut in the amount they are due if the institution concerned gets into difficulties (or, for example, to suffer a forced conversion into equity) has been swept under the carpet since credit market concerns peaked earlier this year, but it hasn’t gone away.

If anything, given public disquiet at the way banks have gone back to “normal” in their pay policies while still relying on taxpayer support, I’d argue that it would be much harder for governments to convince the public that financial institutions must be saved at all cost should we enter a second round of the credit crisis.

But, more importantly, the Bloomberg article tells us that a writedown of creditors’ claims against AIG could quite conceivably have been negotiated and then imposed across the board with little or no warning. Such negotiations were apparently going on in private and, while they didn’t lead to any settlement, it would be foolish to imagine that such a scenario could not happen again.

So, all in all, Matt, while I agree that unsecured debt exposure to banks via ETNs may well make sense for a number of reasons, this type of investment instrument is likely to remain a poor cousin to ETFs in the tracker market. With almost all ETFs, investors are collateralised and shouldn’t have to lose sleep at night over credit risk.

[This blog originally appeared on IndexUniverse.eu, the leading source for insight and analysis into the European ETF market.]

Exchange-traded notes are like the forgotten stepchildren of the ETF industry: unloved and overlooked. Investors (particularly taxable investors) are missing out.

According to the National Stock Exchange, U.S. ETNs had $6.9 billion in assets at the end of September. ETFs were literally 100 times more prevalent, with $697 billion in assets. That included $62 billion just in long commodity ETFs.

That’s just crazy. And it highlights investors’ irrational fear of the ETN product structure.

I remember when ETNs first came to market in 2006: Investors couldn’t get enough of them. Barclays Capital launched the iPath Dow Jones-UBS Commodity Index ETN (NYSEArca: DJP) and it quickly gathered assets.

The reason was simple: ETNs offered two huge advantages over commodity ETFs.

First, they promised perfect tracking. If you bought an ETN, you would receive the full return of the benchmark, minus the fund’s expenses. Period. That’s handy, since commodity ETFs have been more prone to tracking error than most equity funds.

But the real advantage of commodity ETNs was (and remains) their tax treatment. The prospectus said (and still says) that ETNs can be treated basically like zero-dividend stocks for tax purposes. If you hold a commodity ETN for longer than a year, you only pay 15 percent long-term capital gains taxes when you sell. What’s more, you don’t have to pay any taxes until you sell.

By comparison, futures-based commodity ETFs like the PowerShares DB Commodity ETF (NYSEArca: DBC) are treated like futures by the IRS. That means that gains are marked-to-market each year, and investors must pay taxes on those gains at a blended 60 percent/40 percent long-term/short-term capital gains tax rate. For a high-earning investor, that puts the blended tax rate at 23 percent, payable every year.

That’s a huge difference. An ETN investor pays a 15 percent tax rate, deferrable until the ETN is sold; the ETF investor pays a 23 percent tax rate, due annually.

Risk Factor

Why don’t we see more assets flow into ETNs? The only possible reason (short of simple ignorance) is the credit risk.

The N in ETN stands for note, and that’s what they are: unsecured debt notes. Like any other uninsured promise-to-pay, their entire value depends on the credit of the issuing bank. If you buy a Deutsche Bank ETN and Deutsche Bank goes bankrupt, you lose all your money.

It’s not a theoretical fear. The very few people who held the three Lehman Brothers ETNs to the bitter end lost their money when the firm went bankrupt. It’s obvious, looking at the numbers, that the credit crisis stopped the growth of ETNs in their tracks.

But let’s be honest: For an investor who is paying attention, the likelihood of losing money in an ETN is vanishingly small. Most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.

So ask yourself: How likely is it that Barclays Capital or Deutsche Bank, or whomever is underwriting a particular ETN, will go bankrupt with less than 48 hours’ warning? Or to put a margin of safety on it, how likely is it that they will go bankrupt in the next week?

The answer right now is: not very.

For taxable investors who pay attention to the market, read the newspaper, monitor stock quotes, etc., the likelihood of being caught out on an ETN is tiny. Meanwhile, the risk of overpaying the IRS if you buy and hold a commodity ETF is 100 percent.

ETNs don’t make sense for all investors. In nontaxable accounts, I actually prefer ETFs. If you want a truly fire-and-forget investment, where you can walk away for a year or two, ETFs are the way to go. But for taxable investors who pay close attention to their accounts, there’s a lot to be said for the ETN structure.

(One caveat here: There is a risk that the CFTC’s plan to enact new regulations in the commodities market will force some ETNs to shut down. If that happens, investors would get their money back, but they could be hit with short-term capital gains if they’ve held a note for less than a year. It’s tough to gauge how large a risk this is, but it’s legitimate.)

Matt’s ideas for fixing bond ETFs aren’t bad, but focusing on premiums and discounts is a mug’s game.

Matt, I know you love it when issuers come up with creative ways to game the arbitrage process to increase liquidity and narrow tracking error, but the problem here is really more fundamental. The way I see it, bond ETFs will always be fighting two uphill battles.

The first problem is just woolly thinking with regard to premiums and discounts. The reality is that at any given point in time, the true NAV of any portfolio (ETFs included) is a moving target. The way I think about it, there are actually three claimants to the title of “true NAV”:

1. There’s the rollup of all the “bids” in the underlying securities. This would be what the ETF basket would sell for if you could shove the portfolio through the top of the market.
2. There’s the rollup of all the “asks” in the underlying securities. This is what an AP would pay if he had to go buy the basket to deliver to the issuer to make new ETF shares.
3. There’s the rollup of the last traded price on the tape for the underlying securities. This is what gets used to create the NAV at the end of the day.

Each of these NAVs is actually completely fictitious, of course, but they’re the best we have. They’re fictitious because they don’t represent the true market value of one share of an ETF, or the true market value of the entire ETF. The fact that the NAV is essentially always wrong is what allows market makers to stay in business.

Think of it this way: If I have 1,000 shares of IBM stock, it’s not worth exactly the same amount per share as a 100,000-share trade printed last night at 4 p.m. It’s worth whatever I can actually sell it for when I go to sell it. Yet I measure my portfolio against a collection of these best guesses. When we talk about premiums and discounts in any ETF, we’re usually looking at these end-of-day NAVs compared against the end-of-day bid/ask midpoint for the ETF.

Honestly, unless there is a wide disparity between these two (which we’ve certainly seen in some ETFs, notably the U.S. Natural Gas Fund (NYSEArca: UNG) and some high-yield funds like the iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG)) or there’s a consistent premium/discount, I think it’s a bit silly to get hung up on the numbers.

Trends? Sure. But a day or two here or there where there’s a 1 or 2 percent gap between two numbers you can’t trade at? Sorry, not going to sweat it.

The second problem is simply that these funds are bond ETFs. Bond funds have to deal with the same NAV issues as equity funds, but with far more underlying uncertainty. Not only are they extremely optimized―as we’ve mentioned previously in our discussion this week―but the prices for bonds themselves are largely a matter of voodoo and tea leaves.

For something like Treasuries, it’s no big deal―the bonds trade constantly. For corporates, issuers are almost entirely reliant on pricing services that make up imaginary prices for bonds that haven’t traded in minutes, hours, days or weeks based on models that combine the current yield curve, credit ratings, recent trades, sunspot activity and the price of tea.

Again, I’m not saying there’s a magic solution. I actually think the current system works remarkably well. But bonds are simply noisy.

Add the noise of bonds to the noise of doing premium/discount calculations, and the idea that you can get any kind of real, short-term information from a spot-check seems spurious. Bond investors should be thinking long term, and their analysis of bond ETF spreads and discounts should take the long view too.