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 they do not have a tracking error. The value of their shares exactly 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.
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).
Deutsche Bank, for example, has the following ETNs on offer:
- DGZ – 100% anti-gold, moves in the opposite direction of gold. Purchase if you want to profit from gold’s decline (not recommended for most investors, as this means taking positions against the main trend).
- DZZ, GLL – like above, but these funds involve double leverage. In other words, if gold gains 1%, this fund loses 2%.
- DGP – 100% gold, double gold. Moves in the same direction as gold, but involves double leverage. If gold gains 1%, the fund gains 2%.