There is a sudden flurry of exchange traded notes (ETNs) being issued on the Johannesburg Securities Exchange (JSE). Investors must exercise care. Exchange traded notes have many similarities to exchange traded funds (ETFs) but there are very distinct differences, particularly in their risk.
The latest ETNs include the Standard Bank Africa Equity Index which tracks a basket of shares listed on African exchanges, excluding the JSE; and a Rand Merchant Bank ETN which tracks the value of oil futures.
The risk contained in exchange traded products (ETPs) is starting to worry regulators around the world, with some commentators saying that the increasing number of ETPs, particularly ETNs, and other structured index products could spark the next financial crisis, leaving investors, who presume they are in low-risk products, exposed to often undeclared risks.
The main difference between ETFs and ETNs is that ETNs are products where you effectively lend money to a bank, which in return promises to replicate a pre-determined index less investment costs.
In other words, you purchase a debt product similar to a bond, but the performance of the product is linked to an underlying security, basket of securities or index. The guarantor of your investment may or may not actually invest in the pre-determined index. The ETN “promise” is dependent on the financial strength of its issuer (guarantor) to have the money available when you want to sell your investment.
ETFs, in contrast, represent a direct investment in underlying securities that make up a pre-determined index.
Exchange traded funds
In South Africa most ETFs are securities listed on the JSE that track selected indices. These indices may be simple ones such as the FTSE/ JSE Top 40 or a more complex structure such as those used in an enhanced ETF. Enhanced ETFs, such as the Satrix Rafi, use additional “filters” to seek better performance than that provided by the vanilla index. These filters are applied on an unemotional mathematical basis, giving additional weight to such things as the amount of debt companies in the index may have.
An index may also be skewed in favour of a particular factor. For example, in the Satrix Divi the shares in the index are selected based on the dividends paid and not only the size (market capitalisation) of a share.
Most ETFs are registered as collective investment schemes in terms of the Collective Investment Schemes Control Act (Cisca). An exception is the Absa NewGold ETF, which invests in actual gold bullion and cannot be registered as a collective investment scheme because bullion is not a listed security.
There are major advantages for investors in having their ETFs subject to Cisca. These are:
* Counter-party risk. This simply means the credit standing of the guarantor, namely a bank. There is no counter-party risk, because the sponsor of the ETF does not “own” the assets. Your investments are held by a custodian (trust). So if the sponsor goes bankrupt it will have no effect on your investment.
* Diversity. In terms of Cisca there are strict limits on how much may be invested in any particular security, ensuring a spread of investments and lowering risks.
* Actual investment. Your money must be invested in the actual underlying securities, whether it is a share or a bond.
* Derivatives. Derivatives may be used only in a very controlled and limited way to protect you against downside risk. Derivative instruments may not be used in an attempt to improve returns, thereby placing you at greater risk.
* Securities lending. ETFs may lend the securities they own in the derivatives market, reducing costs of investments, but this may also create a risk if the borrower has problems.
* Taxation. The conduit principle of taxation applies. In other words, tax is paid in your hands. This means you pay tax on any interest and foreign dividends on a yearly basis and are subject to capital gains tax when you cash in your investment.
* Open ended: ETFs, like all collective investments, are created and destroyed as they are bought and sold. This ensures that they retain a value close to the total of the value of the underlying investments.
Exchange traded notes
The classic definition of an ETN is that it is an unsecured, unsubordinated debenture (debt security) issued by an underwriting bank that is listed on a registered and regulated stock exchange. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit standing of the issuer.
In other words, ETNs are a promise of payment from an institution – normally a bank – to repay your investment based on a return provided by the performance of a pre-selected benchmark. A benchmark can range from tracking the price of commodities such as silver through to tracking indices made up of a basket of shares.
The underlying investments made with your money may be fully or partially invested in the named investment, such as silver. But often not a single cent is invested in the named investment. Instead, your money is invested in derivative instruments, which the sponsor of the note has calculated (hope-fully correctly) will deliver the promised returns.
ETNs are very similar to the index-linked structured products, which are fairly wildly sold and too often mis-sold under life assurance licences in South Africa to unsuspecting investors. The main differences between an ETN and the index-structured products are that the structured products also offer a partial or full capital guarantee, are far more opaque than ETNs, are not listed securities and never invest in the constituent parts of the underlying benchmarks.
So the risk with an ETN is on the guarantor (bank) to deliver.
The advantage of an ETN is that it can give you cost-effective access to exotic indices such as combinations of markets or parts of markets, currency baskets and other securities that would normally not be accessible through collective investments (unit trusts and ETFs).
ETNs also track what are called “single-reference” investments such as commodities, which often would not be cost-effectively available to investors.
ETNs’ features include:
* Regulation. ETNs are not registered as collective investment schemes. They do pool the money of many investors, but this does not bring them within the protec-tive ambit of Cisca. Banks, as ETN providers, are regulated under the Banks Act and have to hold the required capital as the issuer of ETNs, regardless of whether they are in derivatives or actual securities.
* Counter-party risk. Banks are often as good as their credit rating and the credit rating is as good as the rating agency. One of the major problems in the 2008 sub-prime meltdown was that credit rating agencies simply did not do their jobs properly.
In South Africa, although not involving a bank, the credit rating of the Corporate Money Market fund gave investors little inkling of the parlous state of affairs until the fund’s actual collapse.
The other problem with rating agencies is that they are often in the conflicted position of being both consultants and assessors of risk, and more often than not are reactive rather than proactive in issuing rating downgrades.
The risks to the banks include getting their calls wrong in buying and selling, particularly in the trading of derivatives in the futures market.
The fragility of many banks, exposed by the 2008 sub-prime crisis, is being addressed, with banks, including local banks, being forced in terms of what is called Basel III to hold better reserves to ensure that they can pay back money lent to them.
However, some commentators internationally are warning that the additional capital requirements for banks may simply drive banks into taking greater risks, with such things as ETNs and structured products, to enable them to maintain their levels of profitability.
It must be remembered that it was not just the high-profile bankruptcy of United States bank Lehman Brothers that came in the wake of the 2008 sub-prime crisis. In 2008, 25 US banks had to be rescued, with another 140 in 2009 and 157 last year.
And the damage did not stop there. Banks around the world, from Iceland to the United Kingdom, had to be bailed out to protect depositors from the greed and carelessness of bankers.
An ETN itself has no credit rating, and as with an ETF, it is subject to the vagaries of markets.
* Tracking error. An ETN can be superior to an ETF in that it can be offered with no tracking error. ETF tracking errors can be caused by a number of factors – from delays in the purchase of securities to costs. An ETN provider can simply guarantee the index, usually less costs.
* Returns. Dividends paid by companies in equity-based ETNs are seldom reflected in the return of an ETN, but are sometimes included in the performance of the index on a total-return basis, such as with the latest Standard Bank Africa Equity ETN . Non-inclusion of dividends or interest can make a significant difference to the returns of an ETN compared with an ETF where interest and/or dividends are added in. You should always check this, because it will make a significant difference to performance over the medium to long term.
* Tax. In South Africa, investors in ETNs, as debentures, will pay either income tax or capital gains tax, depending on the length of time they hold the investment. In some tax jurisdictions they are treated as being subject to more favourable capital gains tax.
* Liquidity. The notes, as debt instruments, could have a liquidity problem because a set number of notes may be issued per issue with a fixed redemption date. However, in South Africa the JSE rules for listing ETNs require sponsors, in effect, to be market makers by buying or selling notes to ensure that a fair price is maintained at all times. This overcomes any supply and demand problems that could arise.
In terms of the JSE rules, ETNs have redemption rights. This means the investor can redeem the ETN at the value of the underlying benchmark. But again be aware that the repayment is dependent on the issuer’s ability to pay.
* Complexity. ETNs can be particularly complex. In South Africa so far they been relatively simple, but offshore products are becoming increasingly complex. The old rule applies: if you do not fully understand it, leave it alone – there are plenty of alternatives, including ETFs.
There is no doubt, however, that both ETNs and ETFs offer investors a cost-effective way of investing.