invest in gold


Exchange traded notes are funds that combine the features of ETFs and bonds. Like bonds they have a maturity date and their value depends on the value of a given market index or precious metal (e.g. gold) and the credit worthiness of their issuer. They are distinguished from exchange traded funds by the fact that they do not own gold in physical form – they usually invest money entrusted to them in futures contracts. ETNs are only debt instruments – a promise to pay a specified amount of money, dependent on the performance of a connected index or precious metal, on the day of maturity.

They are a relatively new financial instrument. The first exchange traded note in the world was a fund named iPath, created by Barclays. It was launched on June 12th 2006. Soon after, ETNs created by Bear Stearns and Goldman Sachs were introduced and then ETNs created by other banks, including UBS, Morgan Stanley or Lehman Brothers. Two years after the launch of iPath there were already 56 ETNs issued by 9 banks.

The main advantage of ETNs is the fact that the value of their shares generally matches the value of the index or precious metal they follow. They are not, however, based on this index or metal in any way – they are just a promise to pay out a return equal to the return on the instrument they follow. They are just a debt instrument. Some ETNs offer leverage. This means that their value can increase even several times more than the value of the precious metal or instrument they follow. There are even ETNs whose value rises if the price of gold drops. These may be a good solution for the bear market in gold.

Exchange traded notes are very liquid. They can be bought or sold on the stock exchange any time during the trading session. Their prices are determined by their supply and demand, based on buy and sell orders. They can be resold to their issuer, but that very often involves various costs and commissions.

Their main disadvantage is credit risk – the risk that the firm issuing the ETN goes bankrupt. In the event of bankruptcy it won’t be possible to retrieve gold in any form, since the ETN does not even have it. Its shares are only debt instruments. The bankrupt investment bank Lehman Brothers, issuer of 3 exchange traded notes, is a great example. They are also subject to market risk. Their prices on stock exchanges fluctuate every day and potential problems with the issuer may cause a decline in price. Some may consider a number of fees and commissions involved with exchange traded notes a drawback, as it does decrease the return. Furthermore, since ETNs are a relatively new financial instrument, there is not much historical data on them. Some offer leverage or use short selling, which may constitute another obstacle to assessing them objectively.

Another problem with leveraged ETNs is what is sometimes described as "time decay." Leveraged ETNs have returns that match the returns of the underlying instrument on a daily basis and after multiplication by the relative leverage factor. So, if gold goes up 1%, a x3 leveraged gold ETN would go up about 3%. The key term here is "on a daily" basis. This means that over longer periods of time, leveraged ETNs do not track the price of the underlying asset very accurately. Just imagine gold going down 40% - a x3 leveraged ETN would decline significantly but it certainly would not return -120% since this would imply a negative price.

There's another approach to the phenomenon. Imagine gold at $1,000 and a x3 leveraged gold ETN at $100. Gold goes to $1,100 in one day. This is a 10% daily return. The x3 leveraged gold ETN would appreciate 30%, to $130. The next day comes and gold declines back to $1,000, with a return of about -9.1%. The leveraged ETN goes down -9.1% * 3 = -27.3%. The price of the ETN after the move is $94.55. Notice that gold ends flat at the end of the two days but the leveraged ETN actually loses money. This is an effect of the daily rebalancing of the ETN. It might be argued that "time decay" is the price one has to pay for the leverage embedded in the ETN.

There are many ETNs on the market that follow gold. They are offered by many banks around the world including Barclays, Goldman Sachs, Swedish Export Credit Corp., BNP Paribas, Deutsche Bank, UBS, Morgan Stanley and Credit Suisse. They can also be bought or sold on stock exchanges. The biggest number of exchange traded notes is quoted on the New York Stock Exchange (NYSE).

Janus Distributors, for example, has the following ETNs on offer:

  • DGLD – moves in the opposite direction than gold, with triple daily leverage (x3). In other words, if gold depreciates 1% in a day, this fund gains about 3% for the same day. Purchase if you want to profit from gold’s decline.
  • UGLD – triple gold. Moves in the same direction as gold, but involves triple leverage. On a daily basis, if gold gains 1%, the fund gains about 3%

Please, note that leveraged instruments might be extremely risky and are not suitable for all investors.

Did you enjoy the article? Share it with the others!

Dear Sunshine Profits,

gold and silver investors MARCH 15TH, 2011
menu subelement hover background