Monday, August 18, 2008

Ben Graham meets the Exchange Traded Note

Exchange traded notes (ETN) are a fairly new investment product that share some characteristics of exchange-traded funds, or ETFs. They are simply direct debt obligations issued by a bank or investment firm rather than an interest in a pool of securities that define an ETF.

A bank simply issues a note and promises to pay the holder whatever the total return of an index is over the maturity of the note, less a management fee. The bank may or may not use the cash to invest in the matters not, what an investor should care about is the return on the note which is the return of the index less fees. So long as the bank is solvent, investors will get the returns that they are promised.

An ETF has essentially no credit risk from a fund ETF investor is entitled to his/her share of the collective unit assets. There is always some tracking error risk in that the return may differ slightly from the underlying index.

ETN holders have no tracking error risk but do need to concern themselves with the credit risk of the offeror.

With that intro, proviso, and warning, let's talk about the Ben Graham aspect of ETNs.

Deutsche Bank, a AA-/AA1 bank has issued as of early August, a new ETN whose return is linked to the performance of one of several Benjamin Graham Indices. These securities are senior unsecured obligations of Deutsche. To be clear, these securities are NOT principal protected. The sponsor of the ETN is Nuveen Investments. The indices have been constructed by a Nuveen subsidiary, Hyde Park as part of their ELEMENTs series of product.

"The Index tracks the value of a portfolio of 50 large-cap U.S. stocks that are selected according to the Benjamin Graham Methodology.The Methodology seeks to identify businesses with strong, liquid balance sheets that trade at a discount to their implied intrinsic value, implementing the investment principles of Benjamin Graham through a quantitative, objective process utilizing modern portfolio theory and statistical analysis. The Methodology consists of four steps: (i) Universe Screening, (ii) Stock Selection, (iii) Semi-Annual Re-allocation, and (iv) Annual Reconstitution."
Interesting to see the juxtaposition of modern portfolio theory with Graham Methodology!

Certainly, the essential elements of Graham's theories are in place: The seven major factors are:

1. Earnings Quality – a quantitative analysis that seeks to measure a company’s reported earnings as
compared to an assessment of its true economic earnings.

2. Valuation – an examination of the ratios of a company’s share price to certain financial metrics, including historical earnings and book value.

3. Forward P/E – a ratio of price to consensus estimates of future earnings. Such estimates will be based
on data obtained from one or more vendors who provide consensus earnings estimates.

4. Dividend Yield – the ratio of a stock’s dividend to its share price.

5. Profitability – an evaluation based on measurements of a company’s return on capital.

6. Debt and Liquidity – an analysis of a company’s current assets as well as its ability to service debt.

7. Measurements Relative to Industry Peers – key measurements of valuation and performance compared to average levels within a given stock’s industry.

The seven major factors and their related sub-factors are part of the objective, rules-based,proprietary Methodology. Each major factor has a specified weighting and the sum of all major factor weights is equal to 100%. Each sub-factor has a specified percentage weighting and each group of sub-factors under a single
major factor has a combined weight of 100%.

I think the initial list of large cap names should be of some interest to readers:

Abercrombie & Fitch
Alcoa Inc
Allstate Corp.
Altria Group
AmerisourceBergen Corp.
Analog Devices Inc.
Applied Materials
BJ Services
CBS Corp
Corning Inc
Eli Lilly
Exxon Mobil
Franklin Resources
Gap Inc
Garmin Ltd
Genuine Parts
Genworth Financial Cl A
Halliburton Co
Harley Davidson
Hartford International Group
Home Depot
Host Hotels & Resorts
Illinois Tool Works
International Paper
J C Penney
KLA Tencor
Legg Mason
Magna International
McGraw Hill
Murphy Oil
Noble Corp
Seagate Technology
Southern Copper Corp
Staples Inc
Sysco Corp
Texas Instruments
United Parcel Service
Valero Energy
W W Grainger

There are three ETNs that have been created here with links to the respective prospectus:

* Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
* Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
* Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)

The management fees for all of these are 75 basis points annually. The notes mature August 14th, 2023.

Since ETNs do not pay any capital gains, dividends, or interest over their lifetime, they ought to be superbly tax efficient as what is termed a "prepaid contract," i.e. the difference between the sale and purchase will be classified as a capital gain, and no taxes are due until there is a sale. I do not believe that the IRS has made a definitive ruling into this assertion and a nasty surprise could await!

Finally, even though I have high regard for Deutsche Bank as a solid credit (I, my family, or clients do hold some Deutsche stock and preferred shares,) I cannot emphasize enough the importance of knowing that ETNs are an obligation of this issuer and there is no guarantee as to principal.

Disclaimer: I. my family, or clients have a current position in CBS, Corning, Exxon Mobil, Genuine Parts, Illinois Tool Works, Legg Mason, Pfizer, Sysco, and Wyeth.


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