Explore ETNs, Closed-End Funds, and Alternative ETFs in the Canadian Market with Practical Examples
In the previous sections of this chapter, we have explored the structure, regulation, and varieties of exchange-traded funds (ETFs) in depth. However, ETFs represent only one segment of a broader universe of publicly traded investment products. This section will delve into three major categories often discussed alongside or in comparison to ETFs:
Each product type offers unique benefits, risks, and structural nuances that can influence an investor’s portfolio composition and risk profile. Throughout this section, we will discuss their key features, common use cases in the Canadian market, and regulatory considerations to keep top of mind.
Exchange-Traded Notes (ETNs) are debt obligations issued by financial institutions such as banks. They are designed to provide investors with a return tied to the performance of a specific underlying benchmark or index, minus fees. ETNs trade on an exchange, similar to equities and ETFs, which allows for intraday liquidity.
However, ETNs differ from ETFs in one key aspect: credit risk. Because ETNs are unsecured debt obligations, the solvency and creditworthiness of the issuing institution can significantly impact the ETN’s viability. If the issuing bank or financial institution defaults, investors may only receive partial or no return on the ETN, regardless of how the underlying index performs.
• Principal Protection: Most ETNs are not principal-protected. While some may advertise limited downside protection, investors should carefully read the offering documents.
• No Tracking Error Risk: Because ETNs promise to deliver the total return of the reference index (minus fees), they do not hold a basket of securities as ETFs do. This structure typically results in minimal tracking error but introduces credit risk.
• Fees: ETNs generally have ongoing fees (often deducted from the note’s value) and possibly redemption fees for early redemption prior to maturity. These fees must be accounted for when evaluating long-term returns.
Suppose RBC issues an ETN directly tied to the performance of the S&P/TSX 60 Index. If the S&P/TSX 60 increases by 10% over one year, and the ETN charges a 1% annual fee, the gross payoff to ETN holders (excluding credit risk considerations) would be roughly 9%. However, if RBC faces a significant credit event, the ETN’s value may plummet, even if the S&P/TSX 60 remains robust.
• Credit Risk Management: Check the issuer’s credit rating through agencies such as DBRS, Fitch, Moody’s, or S&P.
• Regulatory Observations: Although primarily regulated under debt securities frameworks, ETNs also come under the purview of the Canadian Securities Administrators (CSA) for market rules.
• Portfolio Positioning: ETNs can offer access to hard-to-reach asset classes or esoteric indexes. However, Canadian advisors must weigh the trade-off between potential lack of tracking error and the added credit risk.
Closed-End Funds (CEFs) are similar to ETFs in that they pool money from investors to invest in a diversified portfolio of securities. However, unlike traditional ETFs, CEFs do not continuously create or redeem shares based on supply and demand. Instead, CEFs often go through an initial public offering (IPO) to raise capital, after which their shares trade on the stock exchange.
A defining characteristic of CEFs is that they may trade at a premium or discount relative to the fund’s net asset value (NAV). This discrepancy arises from market supply and demand dynamics—if there are more buyers than sellers, it can drive the share price above NAV, creating a premium; the reverse situation can lead to a discount.
• Fixed Capital Structure: The number of shares outstanding is typically fixed, which can result in price fluctuations independent of NAV.
• Portfolio Freedom: Because CEFs do not face daily creation/redemption pressures, managers may have more freedom to invest in less liquid or specialized markets such as private credit, real estate, or frontier markets.
• Distributions: CEFs often distribute dividends or interest payments, making them potentially attractive for income-focused investors.
The phenomenon of trading at a premium or discount can be attributed to multiple factors, including market sentiment, the fund’s investment strategy, liquidity levels, and the reputation of the fund manager. In the Canadian market, some CEFs focusing on niche sectors (e.g., real estate investment trusts, private debt) exhibit longer periods of trading at a discount or premium depending on investor demand and perceived asset value.
A hypothetical CEF that invests in high-yield Canadian real estate assets—say, mortgage-backed securities from provinces like Ontario or British Columbia—might trade at a discount during periods of economic uncertainty or rising interest rates. Conversely, if the real estate outlook is positive and demand is high, shares could command a premium over NAV.
• Listing Requirements: Like most exchange-traded products, CEFs must meet standard exchange listing requirements set by regulators.
• Disclosures: Managers must provide regular updates, including NAV calculations and holdings data.
• Oversight: CSA’s National Instruments (for instance, NI 81-101 or NI 81-106) outline disclosure and operational guidelines for funds, which also apply to certain aspects of closed-end structures.
“Alternative ETFs” or “Liquid Alternatives” refer to ETFs that utilize non-traditional investment strategies and/or asset classes. These can include hedge-fund-like strategies such as long/short equity, market-neutral, managed futures, or multi-strategy approaches. Although hedge funds often face liquidity restrictions, alternative ETFs are structured to offer daily liquidity and are subject to regulatory frameworks designed for retail investment vehicles.
• Long/Short Equity: Employs short selling in addition to long positions, aiming to capitalize on both rising (long) and falling (short) security prices.
• Market-Neutral: Attempts to profit from relative mispricings in securities while maintaining minimal net market exposure.
• Global Macro or Multi-Strategy: Deploys multiple techniques, often involving commodities, currencies, and derivatives, seeking absolute returns.
The Canadian Securities Administrators introduced amendments to National Instrument 81-102 (Investment Funds) in January 2019, which paved the way for liquid alternative funds accessible to retail investors. These new guidelines allow asset managers more latitude in leveraging, short selling, and investing in derivatives, but within regulated limits to control risk.
Alternative ETFs can diversify and potentially reduce overall portfolio correlations to traditional asset classes. For instance, a Canadian-based alternative ETF that invests in long/short U.S. equities may hedge part of its currency exposure to CAD. When RBC or TD invests client assets in such ETFs, the goal is often to enhance risk-adjusted returns, particularly during periods of market volatility.
Imagine an ETF that holds a basket of top Canadian banks (going long on shares of RBC, TD, BMO) while shorting a basket of weaker or overvalued Canadian industrial stocks. This strategy aims to generate alpha from both upward and downward price movements. It remains subject to liquidity regulations, ensuring that retail investors can buy or sell ETF units on the TSX without facing the gating or lock-up periods often encountered in traditional hedge funds.
To better visualize how these products differ on key factors such as structure, liquidity, and risk, consider the following diagram:
flowchart LR
A((ETNs)) -->|Credit risk from issuer| B((Investor))
A((ETNs)) -->|Linked to index performance minus fees| D((Market))
C((CEFs)) -->|Fixed capital structure| D((Market))
C((CEFs)) -->|Premium/discount to NAV| B((Investor))
E((Alternative ETFs)) -->|Non-traditional strategies| D((Market))
E((Alternative ETFs)) -->|Regulated liquidity| B((Investor))
When evaluating ETNs, CEFs, or alternative ETFs in the Canadian market:
Conduct Thorough Due Diligence
• For ETNs, verify the issuing bank’s credit rating and financial stability.
• For CEFs, examine historical discounts or premiums to NAV, and understand the liquidity of underlying assets.
• For alternative ETFs, ensure compliance with relevant regulations (e.g., NI 81-102) and confirm the fund manager’s track record in alternative strategies.
Understand the Risks
• Credit Risk (ETNs).
• Illiquidity and Pricing Disparities (CEFs).
• Leverage and Strategy Complexity (alternative ETFs).
Align Products with Investment Objectives
• Evaluate how each product type fits your or your client’s risk tolerance, time horizon, and goals.
• Consider holding ETNs for short- to medium-term strategies only if you are comfortable assuming the issuer’s credit risk.
• Review the discount/premium patterns of a CEF if looking for potential entry/exit points.
• Use alternative ETFs to hedge or diversify risk in a portfolio dominated by conventional equities or bonds.
Stay Informed on Regulatory Updates
• The Canadian Investment Regulatory Organization (CIRO) and CSA often issue bulletins or updates that can influence product structuring.
• Monitor changes to National Instruments (e.g., NI 81-102) to ensure compliance with leverage, derivative usage, and liquidity requirements for alternative funds.
• CSA Guidelines and National Instruments Regulating Non-Traditional Funds:
– National Instrument 81-102 and 81-104 for mutual funds and alternative funds.
• CIRO Bulletins on Structured Products and Alternative ETFs:
– Relevant bulletins provide guidance for advisors on the suitability of these instruments.
• “Alternative Mutual Funds and ETFs” – A Resource on Liquid Alt Regulations in Canada.
By exploring the differences and common features of ETNs, CEFs, and alternative ETFs, Canadian investors and advisors can diversify their strategies, manage risk, and optimize portfolio returns in an ever-evolving financial landscape. This knowledge empowers you to make more informed decisions when recommending or selecting investment products, ensuring alignment with personal or client-specific objectives.
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