Will Exchange Traded Notes become a snare for UK investors?
For UK investors exchange traded notes (ETNs) may look like a cloud the size of a man's hand at present -- there's less than a handful of them available -- but they could become an important feature of the investment landscape over the next few years and a potential danger to private investors who manage their own portfolios.
New but already controversial
ETNs are only four years old even in the US and in 2007/8 they experienced explosive proliferation, growing eight fold in a 12-month period. This fashionability juddered to a standstill with the onset of the financial crisis.
All of a sudden, the fact that ETNs are just a kind of tradable unsecured debt became of overriding significance -- a flaw that investors could afford to ignore no longer. The most high profile casualties were three ETNs of Lehman Brothers, holders of which lost everything.
For a time it looked as if ETNs were destined for the scrap heap of investing history in short order, but more recently it looks as if the ETN model has been making a comeback. The reason for the renewed spurt of popularity is that, unlike exchange traded funds (ETFs) and exchange traded commodities (ETCs), ETNs can track the return of their indices simply on the issuer's say-so. This opens up tricky areas such as volatility indices or crude oil spot prices for tracking.
Time for a fresh safety check
Where have the safety concerns gone? Firstly, provided the issuer hasn't already filed for bankruptcy, institutional investors can sell their ETN shares back to the issuer in bundles of 50,000 (shares) and they'll always receive the value of the index being tracked.
For those with smaller stakes the only exit route is trading, and, if there are worries about the credit-worthiness of the issuer, those worries will be reflected in the share price. In other words, the notes will stop tracking their index and start tracking concerns about the issuer instead.
The exposure to the issuer as a credit risk will still be present even if the investor knows for a fact that the issuer has hedged their exposure to the ETN, as virtually all of them do.
Although ETNs may have significant attractions, especially for those interested in tracking commodity prices, you have to ask if you would see danger signals relating to the issuer before it was too late. As a former HBOS shareholder and Icesave saver, I'm still not sure if I've all the right tools for spotting troubled banks!
There are exceptions though, as some issuers collateralise the net asset value of the notes. This makes such a difference that the ETN issuers that do this would do well to differentiate their product from mainstream ETNs, which lack this safety feature.
The fledgling UK scene
The sole ETN listed on the LSE, Lyxor's ETN Gold (LSE: LTNG), does collateralise and has a variable but significant fee (currently 0.4%) for doing so, in addition to the basic 0.3% expense ratio.
It looks as if the gold ETN may be the first of several -- an oil ETN and a short oil ETN may be next. Like the gold ETN, it will probably be possible to use these ETNs with ISAs and SIPPs.
The likely next provider of ETNs will be Barclays iPath, which already has a couple of S&P 500 VIX (volatility) ETNs listed in Germany that are supposed to be accessible to UK investors. That said, I haven't found an online broker who seems to offer them; including Barclays Stockbrokers. The iPath website is nominally restricted to institutional investors and states that the iPath ETNs are not collateralised.
Although, the ETN area in the UK looks set to grow, it seems unlikely that many London-listed ETNs will obtain the right regulatory approval for being marketed to private investors.
Nevertheless, there's always going to be the possibility that roving share traders will acquire them without being aware of the risks. Although it may be tempting to track, say, the spot price for natural gas, if the notes have no collateral, they don't look right for private investors.
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