Understanding exchange traded products crucial for investors

There has been a proliferation of exchange traded products launched locally in recent years – including Exchange Traded Funds (ETF), Exchange Traded Notes (ETN) and Exchange Traded Commodities (ETC). Despite their growing popularity, it is crucial investo

ETN & ETF

Exchange traded notes (ETN) and exchange traded funds (ETF) are two similar yet distinctly separate types of investment product which, like most investments, offer advantages to a well planned investment strategy, and present dangers to the uninformed.

Both ETN and ETF products seek to offer the investing public the following desirable attributes:

1. Reasonably priced access
2. to a diversified asset pool
3. that passively tracks an index or commodity price
4. within a single exchange traded instrument

In ‘passive investing’, the goal is to provide investors with the return of a given index or commodity, while keeping costs low. Adherents to this approach point to global studies that reliably and consistently prove that active managers, whose fees tend to be much higher than their passive counterparts, struggle to deliver anything more exciting than simply the index return minus their fees over time.

Under the passive investment philosophy, the optimal course of action is to purchase a well-diversified mix of assets in as low cost a fashion as possible. One can view an ETF as simply a vehicle that allows a retail investor to invest passively without having to replicate an index on their own or, in the case of a commodity, without having to purchase a stockpile of precious metals.

ETFs also allow for different investment themes to be created and made accessible in a cost effective manner, such as RAFI fundamentally weighted indices, and dividend weighted indices. One simply calls up one’s stockbroker and purchases a single security that provides the diversification benefits of a broad index or tracks the price of a precious metal.

Similarly, ETNs also provide access to passive indices, but are more flexible in terms of the way in which this is structured, with some offering capital guarantees and payoffs that differ from a traditional investment in equity.

While both ETFs and ETNs are listed on a stock exchange such as the JSE, the most notable difference is that an ETN entails accepting the issuer’s credit risk while an ETF does not.

An ETN is defined by the JSE as an “unsecured, unsubordinated debenture issued by an underwriting bank that is listed on a registered and regulated stock exchange”. In other words it is a debt instrument, and as such relies on the bank issuing the note to remain solvent in order to make payment.

An ETF on the other hand typically invests in the assets that it purports to track and those assets are ring-fenced which means that even if the ETF issuer goes bankrupt the assets still belong to the ETF holder.

This obviously doesn’t mean one should over-react and avoid ETNs as they do offer clear benefits in certain cases, but one should be cognisant of the facts. In practice, the risk of bankruptcy at one of the major South African banks remains fairly remote and their ETN products can provide a great way to invest while limiting the downside in a bear market.

The risk to an ETF, beyond the obvious truth that the investment will lose value if the index it tracks loses value, is the difference in performance between the index and the ETF, known as ‘tracking error’. This may arise from timing lags in purchasing the backing securities, reinvestment of dividends or illiquidity in the market. In practice however, tracking error seldom produces a significant difference in return.

If an investor feels uncomfortable with the risks posed by ETN products, life insurance companies also offer funds that track indices at equally competitive and often lower costs, and that also can be structured to provide capital guarantees. These passive funds are also included as building blocks within Core-Satellite funds and as stand-alone investments in a manner similar to ETFs, while also being guaranteed to have zero tracking error.

The swift rise of the global market for exchange traded funds, which began in 1993 with S&P Depository Receipts (SPDRs), also known as SPiDeRs at the time, and which now encompasses global investments worth over 1.5 trillion dollars, is testament to the fact that investors worldwide will always seek out cost effective ways to manage their money.

It also shows that these products are not the reserve of wealthy individuals or specialist financial advisors, but that they are a fantastic savings tool for ordinary people who wish to invest for the future.