UPDATE: This story has been updated with a statement from Deutsche Bank on its ETFs.
Europe's largest bank, Deutsche Bank (DB) - Get Report , is in the midst of a slow-motion collapse. It's only a matter of time before investors feel the pain. Even if you're nowhere near Germany, your money could suffer collateral damage -- and you need to make sure that doesn't happen. If you own ETFs or ETNs (which are different, but traded in a similar manner), you need to be especially careful.
ETFs are often made out to be easy investments with no decisions, but that's not true. They vary considerably in risk and complexity. Anyone who holds ETFs or ETNs related to Deutsche Bank would do well to read the fund's website thoroughly.
A famous example of an ETN breakdown unfolded with the collapse of the U.S. broker Lehman Brothers, which lead to the 2008 financial meltdown. At that time, three ETNs sponsored by Lehman Brothers stopped trading. Although the ETNs were relatively small with only a few tens of millions of dollars in assets, investors who owned these ETNs were only paid back 9 cents for every dollar invested.
An investor who owns a Deutsche Bank ETN or synthetic ETF -- where Deutsche Bank is also the counterparty -- is essentially lending their money to the bank. And if the counterparty goes bankrupt or suffers financial troubles, the investor bears the risk (I explain how this works further on in this article).
Deutsche Bank is too big to be allowed to collapse entirely. There are millions of people whose savings are with Europe's largest bank. However, investors in Deutsche Bank shares or those who hold counterparty risk are still in danger.
Last month, I wrote about three ways to tell that a bank is in big trouble. Since then, Deutsche Bank has provided a perfect example of all three signs. Senior government ministers and the bank's head have repeatedly insisted that Deutsche Bank is at the top of its game. (If high officials feel the need to reassure everyone that there's no problem, there's almost certainly a problem.) Worse yet, the bank's share price has dropped 46% since the start of the year -- and 11% over the last month -- with no signs of slowing down.
One big way that investors all over the world could be affected is through ETFs and ETNs. Deutsche Bank sponsors (or manages) over 200 ETFs and ETNs in 10 stock exchanges all over the world -- with combined assets of over $40 billion. Here is a list of some of these.
Some of Deutsche Bank's largest ETNs traded in New York (in terms of assets) include the $349 million Deutsche Bank FI Enhanced Global HY ETN (FIEG) - Get Report , the $146 million DB Gold Double Long ETN (DGP) - Get Report and the $66 million DB Crude Oil Double Short ETN (DTO) - Get Report . Deutsche Bank is also the largest ETF sponsor in Hong Kong and Singapore (in terms of total product offerings) with 35 ETFs listed on the Hang Seng and 45 listed on the STI.
So what happens to an ETF or ETN sponsored by Deutsche Bank if the bank collapses and needs to be bailed out?
To answer that question, let's start by addressing the differences between an ETF (Exchange Traded Fund), a synthetic ETF, and ETN (Exchange Traded Note).
"ETF" is a broadly used term that describes exchange-traded investment funds. However, there are two different types of ETFs: Exchange Traded Notes and Exchange Traded Funds.
Owning an ETF means having an ownership stake in a pooled investment that is structured as an independent entity. Most ETFs track a target index by holding many or all of the underlying securities in that index (a "physical" ETF). Owning this type of ETF means owning a small share in a company that's investing in many different stocks. For example, having an ETF in the S&P 500 means that you own a small piece of each of the 500 securities (or at least some subset of them) that make up the S&P 500 Index.
ETFs are independent of managers, issuers and sponsors. The shareholder would usually still receive cash for the market value of the securities even if the ETF provider were to shut down or go bankrupt.
However, physical ETFs are quite different from ETNs and synthetic ETFs. These types of ETFs usually do not hold actual securities. Rather, they "engineer" the specific index's returns.
An ETN is a bond issued by a financial institution. It is not an independent pool of securities like a physical ETF. The company promises to pay ETN investors a return on an index and give back the principal when the investment reaches maturity.
Many ETNs track commodity indices. Managing commodity ownership for each investor is a lot of work -- replicating a commodity index's returns is much easier and more profitable.
Owning an ETN essentially means lending money to the issuing company and receiving a return on an index. ETNs do not own anything, and they have no collateral. Most importantly, they carry the credit risk of the company that issues them. If something happens to that issuing company, an ETN could be left worthless.
One of the largest ETNs (in terms of assets) is Barclay's iPath Dow Jones Commodity Index (DJP) - Get Report . This index tracks grains, livestock, energy, industrial metals, precious metals and other commodities. Investors who purchase DJP may think they own commodities, but they don't. What they own is a promise from Barclays (BCS) - Get Report to pay a return based on the theoretical distribution of the commodity index. If Barclays went bankrupt, owners of DJP would lose their investment.
A synthetic ETF is similar to a physical ETF, but instead of holding securities from an index, the ETF owns "swaps" (contracts with another financial institution, or "counterparty", that promises to pay return on an index) and other collateral that replicate holdings. This method reduces the fund's costs by using derivatives instead of buying the underlying asset. These savings are then passed on to the investor. But, if a counterparty cannot pay, an owner of a synthetic ETF could lose their investment.
Deutsche Banks is a counterparty for many synthetic ETFs. And for some, it is the only counterparty. The biggest risk for a synthetic ETF is that a counterparty could fail.
"Our US-listed ETFs are all physically replicated while our European-listed ETFs comprise both physical and synthetic replication," wrote Deutsche Bank in a statement emailed to TheStreet. "Overall, the majority of our ETF assets replicate indices using physical replication and not swaps. Those that do use swaps are well within the UCITS counterparty risk requirements, which means there is very little counterparty risk present."
Here is an excerpt from Deutsche Bank's ETF website describing the Euro Stoxx 50 UCIYS ETF (based in Singapore) with S$7.45 billion in assets:
"The ETFs may enter in over-the-counter derivative transactions such as swap(s) which will expose the relevant ETF to the credit risk of the counterparties to such transactions. The NAV of the relevant ETF may have a high volatility due to its investment objectives, policies or portfolio management techniques. Please refer to the Singapore Prospectus for more details. The swap counterparty is currently Deutsche Bank AG. This may give rise to potential conflicts of interest. Information on the creditworthiness of Deutsche Bank AG can be found at www.db.com."
Both ETNs and synthetic ETFs rely on their sponsoring banks to follow through on their promises to pay dividends on the funds they are tracking. If the sponsoring banks do not (or cannot) follow through, then investors in ETNs or synthetic ETFs could lose most or all of their investment.
Here's a list of Deutsche Bank ETFs and ETNs that are traded in Hong Kong, Singapore, London and New York. The list tells whether these funds use swaps or derivatives (that is, if they're "synthetic"). Some markets, including Singapore, offer some protections, but it's still wise to check anyways.
You can also check yourself on Deutsche Bank's ETF website. Choose the country of interest on the left, then links to specific funds can be found on the bottom right. Under ETF details, check "Index Replication Technique" to see if the ETF uses Direct Replication (that is, if it's a "physical" ETF) or Synthetic Replication (synthetic ETF). As discussed, Direct Replication has much less risk. Read the prospectus listed under "Documents and Downloads."
The future for Deutsche Bank is uncertain. But in view of the many alternatives in ETF products, some investors may decide to sell Deutsche Bank-sponsored fund that uses derivatives, where Deutsche Bank might be a counterparty. As well, many other ETFs and ETNs may use Deutsche Bank as a counterparty even if they are not sponsored by the bank.
Kim Iskyan is the founder of Truewealth Publishing, an independent investment research company based in Singapore. Click here to sign up to receive the Truewealth Asian Investment Daily in your inbox every day, for free.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the investments mentioned.