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When researching last week’s column on the differences between exchange traded funds (ETFs) and exchange traded notes (ETNs), I ran into some confusion in the industry over whether Absa’s NewGold ETF is, in fact, an ETF or whether it should be classified as an ETN, particularly since Standard Bank’s commodity products are ETNs.
Clarification on this issue is important because:
* NewGold – with R16.7 billion under management, making it the single biggest local ETF – is the most cost-effective way for you to invest in gold; and
* It impacts on the risk you are taking when deciding whether to invest via an ETF or an ETN.
Both ETFs and ETNs are listed as securities on stock exchanges, and in South Africa they are subject to regulation in terms of the Securities Services Act and the rules of the Johannesburg Stock Exchange (JSE).
Both instruments may track pre-selected indices made up of a basket of underlying investments or a single investment, such as the price of gold, with low investment costs.
Last week ended with Mike Brown, who introduced the first Satrix ETFs in South Africa back in 2000 and is now managing director of exchange traded product specialist company etfsa.co.za, raising the question with the JSE about whether NewGold should be considered an ETN rather than an ETF.
To recap, the three divisions of exchange traded products currently available are:
* ETFs that are registered as collective investment schemes (CISs) subject to the Collective Investment Schemes Control Act (Cisca). The main requirements for CIS ETFs (apart from money market ETFs) are that they:
- May invest only in listed securities and the securities must be in direct proportion to the index being tracked. For example, if company A makes up 10 percent of the index, the company’s shares must comprise 10 percent of the ETF.
- Must have a spread of underlying investments to ensure diversification of risk.
- Must appoint a custodian to hold the securities in trust on your behalf. In other words, the ETF originator never owns the shares, which must be capable of being delivered to you.
* ETNs. These are tradeable debt instruments (debentures) where effectively you lend money to a originator, normally a bank, which guarantees to deliver to you at a fixed date a return that replicates a pre-determined index less costs.
In other words, you purchase a debt product, but the performance of the product is linked to an underlying security, basket of securities or commodity.
The guarantor of the investment may or may not actually invest in the pre-determined index. The ETN “promise” is dependent on the issuer (guarantor) having the money available when the investment matures. So an ETN has greater risks than an ETF.
* ETFs that are not registered as CISs. These fall somewhere between a CIS ETF and an ETN, and so does the risk. The big differences are that with a non-Cisca ETF you may be invested in a single investment, such as gold, and you may be investing in a debenture rather than directly owning the underlying asset.
According to Andre Visser, the JSE’s general manager in charge of issuer services, when the first Satrix ETFs were listed there was no option to register as a CIS.
ETF listings requirements in 2000 and now do not stipulate that an ETF must register in terms of Cisca to obtain a listing, but all ETFs and ETNs must meet the JSE’s listing requirements.
Visser says these include:
* Underlying assets must be sufficiently liquid and transparent to ensure proper tracking and pricing;
* Daily publication of the net asset value and index level;
* The ETF must be fully funded. In other words, no money can be borrowed by the originator of the fund to buy underlying assets;
* The ETF must be fully covered at all times by the underlying assets;
* The ETF originator must demonstrate that it has the expertise to manage an ETF;
* The structure must be insolvency remote. If the originator goes bankrupt, your assets cannot be claimed by other creditors, as could happen with an ETN.
Visser says the JSE makes sure that there is sufficient separation of authority to reduce any possibility of manipulation by any one party. For example, there has to be independence between the ETF issuer and the index calculation agent.
The JSE ensures that if the ETF tracks an index, the index is properly constituted and calculated by an acceptable party.
In a nutshell, an ETF’s only reason for existence must be the issuing of units and the holding of the underlying assets.
Visser says that at the moment ETFs are passive investments. There is no discretion for the manager other than tracking the selected index.
“We insist on the appointment of a market maker that must maintain a reasonable bid and offer on the market to provide the required liquidity to ETF investors,” he says.
So Visser says that although non-CIS ETFs are different from CIS ETFs, investors still have a safe investment. Investors are obviously still exposed to the performance risk of the underlying assets.
There is no JSE listing requirement to offer investors the option, as required for a CIS ETF, to redeem the underlying physical asset, such as the shares listed in an index or a bar of gold bullion. Any redemption “is therefore completely voluntary”.
But ETFs are required to hold the underlying physical assets of the tracked index. So while they do not have to hand over the asset to you, they must invest in the asset. Remember, an ETN does not need to invest in the underlying asset.
Now to the NewGold ETF, which is not registered as a CIS. The ETF tracks the rand price of gold and is a passive investment with no discretion to the manager. But you do invest via a debenture, which makes it similar to an ETN but without being exposed to originator risk.
Vladimir Nedeljkovic, the head of investments at Absa Capital, says investors are not exposed to Absa risk as they could be if NewGold was an ETN. The NewGold ETF is issued by NewGold Issuer, a special purpose company that is owned by an owner trust with independent trustees. Absa is just a discretionary beneficiary of that owner trust.
Nedeljkovic says that if Absa ever went out of business, NewGold would remain as is.
“NewGold Issuer has been structured (as required by the JSE) to be insolvency remote (restricted activities, no debt allowed, and the only asset held is gold). In addition, qualified investors, namely those holding necessary permits and a sufficient quantity of NewGold ETFs, can exchange them for bullion.”
Nedeljkovic says that, unlike with the NewGold ETF, ETN holders do not have any recourse to the underlying asset and are not ring-fenced from other debt holders. ETN holders cannot exchange their instruments for physical assets (as generally there are no physical assets there at all – everything is hedged using derivatives).
Visser says, based on the facts, from a JSE point of view NewGold is an ETF. “The fact that the instrument being used is a debenture may cloud the matter slightly, but we consider substance over form and look at the principal risk assumed by the investor. Historically, the reason NewGold was structured as a debenture was because it was driven by the mining regulations, which require ordinary investors of ETFs to obtain permits for holding the gold, which would make the product unfeasible.”
For the record, Standard Bank’s single-commodity products are classified as ETNs because you are lending money to the bank on the promise that it will provide you with a return equal to the value of the commodity (less costs). No money is invested in the actual commodity and no one has a right to demand the actual commodity, and the debt is on the bank’s balance sheet.
So it is degrees of security. As an investor you have greater security with a CIS ETF, slightly less with a non-CIS ETF and a bit less with an ETN – but even with an ETN your risk is mitigated by the regulations that the JSE has in place. The JSE is currently revising the definitions of exchange traded products.