In Parts 1 and 2 of this series, we discussed exchange traded portfolios (ETPs), namely funds (ETFs) and notes (ETNs) in terms of their structural and operational characteristics. In this concluding article, we’ll look at practical considerations facing investment compliance professionals using the example of exposure to gold.
Why gold? The majority of institutional investment managers who might utilize a gold ETP would not be focused on commodity investment. It’s much more likely that an equity or debt focused fund manager might use a gold ETP to create exposure to an alternative investment class without the expense of constructing a vault in the break room. Because of this, and the way in which data providers classify ETPs at a high-level, a gold ETP is more likely to trip up a well-intentioned investment compliance program.
As an example of what can go wrong, consider SSGA’s GLD ETF, which holds only physical gold bullion. IMP witnessed a fund with a prohibition against precious metals miss a purchase of GLD. The reason? The pre-trade compliance system considered GLD to be an equity. It trades on an equity exchange, it has an equity security type from data providers and it was set up as an equity by a data management team unfamiliar with the nature of exchange traded portfolios. It’s not hard to imagine.
Equity trades are easy to evaluate because they represent (drumroll) equities! Likewise bonds and cash are similarly straightforward. ETPs, by contrast, often represent something completely different than their own mechanical structure might indicate. Yes, GLD trades on an exchange but the similarity to equities ends there.
GLD is a passively managed 1933 Act trust. Its gold is owned by the trust, not by the GLD holder. In fact, the gold is held in a designated account at a custodian, meaning that it does not appear on the custodian’s books. This may impact firms who include custodian-held assets in their company exposure metrics. Consider that a custodian bank may also be the issuer of a bond, the counterparty to a swap, and a publically traded company, potentially all owned by a fund.
Another important question would be the sources of country risk. GLD’s sponsor and investment advisor are both US, the sponsor’s parent is Swiss, and the physical assets are custodied in the UK. Other providers of structurally identical physical gold ETFs use multiple custody banks in multiple countries.
PowerShares’ DGL is similar in intent to GLD but could not be more structurally different. Like GLD, it has a single asset focus. However, unlike GLD, it does not hold a single ounce of physical gold. Instead, it holds a series of exchange-traded futures contracts. As such, it’s a commodity pool regulated by the Commodity Futures Trading Commission (CFTC). Nonetheless, it’s an ETP whose shares are listed on and trade on NYSE Arca. Because the holdings are futures contracts, accounts with weight limitations or outright prohibitions on derivatives might impact DGL positions.
UBS Etracs’ UBG also tracks a gold futures-based index, but it is an Exchange-traded note (ETN). The holder is paid on the change in value of the UBS Bloomberg Gold Total Return Index, an obligation backed by the parent bank. Holders of UBG are thus debt-holders and unsecured UBS creditors, since UBS is not obligated to own any gold nor futures contracts. This makes compliance somewhat more straightforward, although while UBG trades on equity exchanges, positions represent debt issued by UBS. From a country and issuer exposure perspective, your firm’s treatment of corporate bonds should act as a good proxy.
An ETN’s connection to assets such as precious metals and derivatives is indirect, which may enhance a fund’s ability to hold positions. It is tantamount to a “No Tobacco” portfolio holding an S&P 500 indexed ETN. The returns are in part driven by Philip Morris, but no MO shares are necessarily held.
Because ETN’s returns are based on performance against an index, they enable a myriad of different exposure profiles. For example, Credit Suisse XLinks’ GLDI ETN is linked to a covered call writing strategy against SSGA’s GLD ETF. Credit Suisse may or may not own any GLD or write any calls against GLD. The GLDI holder will not and need not know.
Another hybrid is AdvisorShares’ GEUR which is a rare actively-managed ETF. This open-ended fund provides exposure to gold denominated in Euros. It invests in gold futures and other ETFs, while selling short currency futures. Unlike ETNs, GEUR actually takes positions in these assets. A “US Only” portfolio would need to tread carefully, since GEUR is merely quoted in USD.
Returning to terra firma, Market Vectors’ GDX is an ETF which invests primarily in gold mining shares. It’s not a pure gold play, since slightly less than 86% of investments are in the gold sector (as of this writing). It also has global exposure. However, GDX could legitimately be considered an investment in equities.
ETPs provide liquidity and cost efficiencies for managers. They present access to strategies which might be impractical to manage in-house. Policy issues such as those raised above should be in place well before ETPs are purchased. Then, careful security setup and rule construction will mitigate the risk of having an unexpected holding.
The ETPs discussed in this article were chosen for illustrative purposes due to their structural diversity and for no other reason.