ETPs listed on London Stock Exchange
to invest in single commodities
rather than diversified
indexes. But there is a
strong case for including a
more diversified commodity
vehicle in a portfolio
because it can actually
reduce the overall risk and
provide much needed
diversification in difficult
market environments.
At present it is hard not
to conclude that commodities
behave as a geared
version of equities, which
in the short term will go up
more than equities when
they rise, and fall more
when equities fall. In my
view, investing in a single
ETNs 0.02%
ETFs 72.5% ETCs 27.3%
Source: London Stock Exchange website, Jan ’10
commodity ETC rather than
a general commodity ETF
would lead to much greater
risk both in terms of
volatility and legal status.
l Buying a promise
The third type of exchangetraded
product is an ETN,
which trade on an exchange
like an ETF, with one significant
difference – they
are debt securities, not
equity securities.
When an investor buys
an ETF they are buying a
slice of a diversified portfolio
of stocks. When they
buy an ETN, they are
Plain Talk.
INDEX INVESTING EXCHANGE-TRADED PRODUCTS
buying a promise – specifically,
the promise that the
issuer will pay the note
according to the terms laid
out in the ETN’s prospectus.
This carries significantly
more risk than an ETF.
The problem is simple –
what guarantee do you
have that the counterparty
will be around to make
good on its promise? The
answer is none.
This was highlighted in
September 2009 when 113
ETNs were suspended. The
counterparty was the struggling
insurer American
Insurance Group. This led
to the issuer ETF Securities
suspending 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.
l Secondary labels
Once there is clear, understandable
labelling of
exchange-traded products
by manufacturers, and
investors are educated
about the differences
between the products, then
secondary classifications
that should be considered
would be about legal status
and tax status.
This would tackle
whether ETFs are:
� Physically-backed or
swap-backed: Physically
backed ETFs have the
disadvantage that they
are likely to deviate from
the index by more than
swap-backed ETFs. They
do have the advantage
of reducing costs through
lending out stocks/
bonds and having less
counterparty risk (with a
swap-based ETF a bank
is guaranteeing the
market return will be
delivered). While each
provider will argue their
method is best, in practise
the tracking error
and the counterparty
risks are very small and
therefore the best strategy
is to have different
providers and different
structures to even further
diversify these small
risks.
� Leveraged or short of the
underlying market:
Leveraged ETFs are
designed to provide up
“
When an investor
buys an ETF they are
buying a slice of a
diversified portfolio
of stocks. When they
buy an ETN, they are
buying a promise
– specifically, the
promise that the
issuer will pay the
note according to the
terms laid out in the
ETN’s prospectus
”
We believe in making life simple. Which is why we always
communicate in a manner that leaves no room for doubt – and
in a way that leaves nothing out.
Our approach is to use Plain Talk ™ in everything we do.
So whenever you deal with us, the benefits should
always be clear.
Plain Talk. It’s the Vanguard Way. ™
0800 917 5508 vanguard.co.uk
This advertisement is directed at investment professionals in the UK only and should not be distributed to, or relied upon by retail investors. It is designed only for use by, and is directed only at
persons resident in, the UK. Vanguard Investments UK, Limited only gives information on products and services and does not give investment advice based on individual circumstances. The value of investments,
and the income from them, may fall or rise and investors may get back less than they invested. Issued by Vanguard Investments UK, Limited which is authorised and regulated in the UK by the Financial Services
Authority. © 2010 Vanguard Investments UK, Limited. All rights reserved. UK10/0151/0410
MARCH 2010 [www.portfolio-adviser.com] PORTFOLIO ADVISER
55
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