Not all trackers are as straightforward as good old index funds and Exchange Traded Funds (ETFs). A profusion of less familiar, riskier tracker types skulk in the shadows, beyond the ken of most mainstream investors.

Yet the release of the RBS UK small cap tracker showed that even humble private passive investors may encounter one of these beasts.

So what do we need to know?

Introducing ETNs

Exchange Traded Notes (ETNs) and Certificates are like the grizzly bear and the brown bear of the investing world – one’s of American descent and one’s European, but fundamentally they have pretty much the same snarl. So for simplicity’s sake, I’ll just refer to ETNs for the rest of this article.

ETNs are related to ETFs in that they track an underlying index and are traded on the stock exchange. But there are key differences that make ETNs much riskier than vanilla ETFs:

Like an ETF	Not like an ETF
Tracks an index	They’re debt securities
Trades on the exchange	Can track a single asset e.g. crude oil, volatility
Has ET in the title	Exposed to more counter-party risk – up to 100%

How ETNs work

An ETN follows its underlying index like a train on a track. But where you need to look lively is that ETNs are often used to track exotica like future contracts, volatility indices, currencies or even just half a dozen stocks you might fancy a punt on.

Unlike ETFs, ETNs are not bound by European UCITS regulations that require an investment vehicle to follow a diversified benchmark. So you can indulge your tastes for the weird and wonderful with all the added spice and risk that entails.

An ETN doesn’t actually own the assets that physically comprise its index. Instead, like a synthetic ETF, it uses investors’ cash to buy a derivative.

The derivative is calibrated to pay out the return of the index minus the ETN’s fees. Hence it simulates owning the constituents of the index without the expense of trading in the stuff.

In tandem with the remit to concentrate on single assets, that makes ETNs an inexpensive way of tracking otherwise illiquid and inaccessible markets.

But while an ETN sounds as handy as unmanned space probe to Saturn, the downside is it can come apart like Beagle 2. The derivative payments are made by a counter-party (usually a giant investment bank) and if it blows up then the haircut is likely to be a skinhead. (More on this below).

Many ETN factsheets will mention that the product tracks its index at a ratio of 1:1. This means that there is no leverage involved in the investment and a 1% increase in the price of the underlying asset translates into a 1% increase in the price of the ETN.

If the ratio isn’t 1:1 then you’re double-downing with leverage and piling on the risk.

Getting into debt

ETNs are a debt instrument: in exchange for your cash, you get a promise that the issuer will pay you a return in the future. That has a number of implications for the ETN feature set:

• ETNs often have a specific maturity date like bonds.
• The return is only paid out on that date.
• The return is the value of the index (minus fees) on the maturity date.
• Dividends may or may not be included.
• Dividends are included if the index is total return (TR).
• Income distributions aren’t paid before the maturity date.
• ETNs without a maturity date are described as open-ended.
• If the counter-party goes bust then you’ll have to join the queue of other creditors demanding their money back.

ETNs are often said to be unsecured debt, but in fact many of them are backed by collateral.

Collateral is the air bag protecting you from the impact of a default. Without collateral you’re 100% exposed to counter-party risk.

Even if the ETN is collateralised, the amount of collateral held is at the whim of the bank. It could be anywhere from 1% to 100%, unlike ETFs which must be at least 90% backed.

While it’s hard to imagine any of the too-big-to-fails going down in the near future, UK banking regulation appears to be preparing for the day. Moreover, investors in a few Lehman ETNs were wiped out in 2008.

Exchange bait

Although most ETNs don’t actually pay a return until maturity date, retail investors can still make money by trading them on the exchange.

Market makers ensure ETNs trade close to the price of the index by exchanging ETN shares with the issuer for the current value of the index.

However, the perceived credit risk of the counterparty can also influence the ETN’s price on the exchange, potentially derailing it from the index it’s meant to be tracking.

Cheap and fearful

ETN costs will often be quoted as an annual management charge (AMC) rather than a Total Expense Ratio (TER).

Some ETNs also throw in fees for hedging against currency fluctuations, and these fees can change on a daily basis.

You’ll find yet other products that don’t charge any fees at all, and these miracles of financial engineering presumably cash in with juicy bid-offer spreads where the issuer is the only market maker.

You’ll also pay a commission to trade via your broker and it’s worth taking a good look at the ETN’s tax status too.

Though ETN’s are debt instruments many seem to be liable for capital gains tax rather than income tax. The tax law still seems to be solidifying on this one, so I wouldn’t take anything for granted. You can also render the whole worry moot, but dropping them into an ISA or SIPP.

On the upside, with ETNs you won’t get stung for stamp duty nor should tracking error be a problem, as the issuer promises to pay the value of the index (less any fees, of course).

Why use ETNs?

ETNs are meant to be a low cost route to portfolio diversification.

For example, if you plumped for the RBS Emerging Market Tracker (annual fee = 0) then you can gain exposure to the world’s hottest economies far more cheaply than through an ETF or index fund.

But I’m not tempted for a number of reasons:

• The heightened counter-party risk is not to be sneezed at. While it’s easy to think of the investment banks as impregnable fortresses buttressed by government backing, the deteriorating situation in Greece is a timely reminder that global financial markets are far from stable.

• Less apocalyptic, but adding to my sense of unease, the general standards of transparency relating to ETN documentation and websites are poor. I’m not going to invest in something that feels shrouded in mystery.

• There are countless variations on the theme. Watch out for leveraged versions, discounted trackers that keep the dividends in exchange for a cut-rate starting price, barrier levels and bonus levels… rampant innovation causes investing accidents.

• More than anything, the principles of passive investing rely on accepting the return of a diversified portfolio that invests in broad market indices. By contrast, most ETNs focus on thin wedges of the investing pie that expose investors to risks there’s no real need to take.

Take it steady,

The Accumulator