Exchange-traded products are constantly evolving to provide exposure to new asset classes. But it's hard to see the value in some of the latest innovations.Take the GS Connect Exchange Traded Note (GCE) - Get Report -- if that is even the right name. The product, which tracks the Claymore CEF Index of closed-end funds, started trading Dec. 10, but until last week, there was no information about it on Claymore's Web site. Even now, I can't find the same name for the fund in any two locations.
Unlike exchange-traded funds, which are baskets of stocks or other securities, exchange-traded notes don't hold anything. GCE shares simply represent a promise from
that investors will receive the same return as the closed-end fund index, minus expenses.
I believe Goldman offers the investment strategy through an ETN because it would be difficult to create and redeem shares of an ETF that invested in closed-end funds, which can be very illiquid.
The Claymore index is composed of 75 closed-end funds that are weighted primarily by favoring those trading at large discounts to net asset value. (Closed-end funds issue a fixed number of shares and the market price can move above or below the net asset value.) The index's weighting methodology gives a secondary nod to yield.
GCE charges an expense ratio of 0.95% and pays a quarterly
dividend that is expected to yield 6.75% on an annualized basis. The average discount on the closed-end funds in the underlying index is 10.51%.
As is often the case with new investment products, the back test of GCE's results is compelling: The methodology has bested the
in a meaningful way over the past five years. But if you look closely at the results, you will see there are several periods when the index took severe downturns. During times of market panic, closed-end funds often overreact; discounts widen as the shares sell off faster than their holdings. This has been the case in the past and will be the case in the future.
This behavior is not a reason in and of itself for avoiding GCE or buying it, but you should understand how the product is likely to respond in future periods of market turmoil.
(If you look at a chart of the historical prices of GCE, you will see that on Jan. 4 it appears to be down about 10% but it was actually just the fund going ex-dividend.)
GCE's benchmark rebalances once a year, so anyone buying the ETN will need to live with the current mix until next December. This is relevant because the two largest index constituents are the
India Fund (IFN) with a weighting of 7.95% and the
Morgan Stanley India Investment Fund (IIF) at 4.91%.
That's right, almost 13% of the index is in India. So if India has a good 2008, GCE probably will, too; but if India does poorly I would expect GCE to struggle.
Also in the mix are other emerging market funds, a few call-writing funds and varying types of fixed-income funds. Really the index is a mish-mash of different sorts of exposures. My hunch, assuming nothing dramatic happens to India, is that these exposures might generally cancel each other out and so the fund may not do much.
Another concern is that there are more and more ETFs and ETNs that offer exposure to both domestic and foreign bonds, which have traditionally been the realm of closed-end funds. If the ETF and ETN structures prove to be superior ways to access these asset classes, that would translate into less demand for closed-end funds. Obviously, that would not be good for GCE.
Finally, any strategy that involves gaming discounts vs. premiums of closed-end funds is invariably more complicated than it seems. I think the potential for unintended consequences is higher than with most other products. Will the discounts in the underlying holdings cause GCE
to trade at a discount to NAV for some unexpected reason? Or maybe a premium?
I think that anyone interested in GCE would be well advised to let the fund prove itself before investing.
At the time of publication, a client of Nusbaum's was long IIF, although positions may change at any time.
Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;
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