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Take note of etn dangers

A recent report from Barclays Stockbrokers shows that investors trading in exchange traded funds increased by 162 per cent from October to December 2008, compared with the previous three months.The number of accounts holding ETFs increased by nearly a quarter (23 per cent) and today half of investors hold ETFs within stocks and shares IsasThis is an extraordinary growth story, particularly as it has been achieved in the face of growing economic uncertainty and equity market declines. However, within this trend is a subplot of its own that most investors do not appreciate – the growth of exchange traded notes. ETFs remain the dominant share class with an asset value of £430bn but ETNs now account for £4bn of this and the number is increasing.

Spot the difference

ETNs are, for the most part, very similar to their cousins but there is one fundamental difference – they are a debt security, not equity.

When you buy an ETF, you are buying a slice of a diversified portfolio of shares. When you buy an ETN, you are buying a promise – the promise that the issuer will pay the note according to the terms laid out in the prospectus.

The sponsor of an ETN, such as Barclays Bank or Morgan Stanley, creates a promise to pay from some counterparty to the investor on the eventuality of a certain event.

By buying the ETN, the risk is being passed onto the investor. The daily price of that promise moves up and down based on the price of the underlying security but the ETN has also introduced counterparty risk to the investor.

Another way to think of an ETN is like a corporate bond. Generally, a bond will pay a fixed rate of interest at maturity.

The ETN, instead of paying interest, pays a capital sum. The amount is determined when the investor decides to cash out his interest in the contract. The counterparty will then pay the sponsor the value of the contract. If some event causes the counterparty to not be able to honour that commitment, then the investor is at risk.

An example – investors have already been warned

Last summer, crude oil prices surged to a record high of $147 per barrel. One method by which retail investors sought to participate in this was through the use of ETNs, such as ETFS Petroleum, designed to track the return of a crude oil price index.

Contrary to what many investors believed – that they were buying oil – they were actually buying a promise from the issuer. In this case, the sponsor, ETF Securities, promised to pay a return linked to the performance of the DJ-AIG Petroleum sub-index at some date in the future. But with no claim on any particular assets, investors effectively became unsecured, subordinate creditors to the firm.

The problem with this is simple – what guarantee do you have that the counter- party will be around to make good on its promise? The answer is none.

This was highlighted in September when 113 ETNs were suspended. The counterparty was the struggling insurer American Insurance Group.

In a defensive move, ETF Securities suspended trading in all products associated with AIG as it awaited the insurer’s fate. At the time, AIG stood as counterparty to over £1.4bn worth of DJ-AIG contracts.

The advantages

Reading the above, an investor might rightly question the sense in using ETNs, particularly when their fund siblings appear much less risky.

However, ETNs do have certain advantages not shared by their close cousins. One of the most important is the lack of tracking risk. This means that price of the ETN exactly reflects the underlying index.

ETFs can differ from their net asset value, sometimes significantly, distorting an investor’s returns against an index.

Another big advantage for ETNs is their tax status.

As ETNs are effectively prepaid forward contracts, in which the issuer agrees to pay holders an amount based on specific criteria, rather than offering them an interest in a pool of assets, they do not generate taxable income to investors.

The income gets added to the price of the security rather than being paid in cash, therefore holders do not pay tax on that income until they sell or redeem their ETN.

Although at the moment this is only a legal opinion offered by prestigious law firm Sullivan & Cromwell, it is widely expected to be held true by HM Revenue and Customs.

The business of bank loans

Despite their advantages, worries persist, particularly with investors keen to jump on the ETF bandwagon hoping to recoup some of the heavy losses incurred in 2008.

The worry is that investors do not realise the significant differences between these two investment vehicles. This importance cannot be understated. As Barclays iShares website says: “Not all ETFs are created equal.”

Before investing in the latest gold fund, be sure to understand what exactly it is you are investing in. The first place to start is the issuing company’s own prospectus or factsheet.

There is a vast array of funds available offered by a multitude of providers, including the likes of Barclays Bank, Morgan Stanley, Swedish Export Credit Group and Deutsche Bank.

The problem facing the investor is the same with each. Buying an ETN, rather than an ETF, means you will not actually have a direct holding in the underlying security. Instead, you are making a loan to the issuer.

In this market, when the prospect of nationalising banks threatens to wipe out ordinary shareholders completely, would you really bet on getting all of your money back? By investing in the ETNs, that is exactly what you are doing.

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