Investors are constantly seeking new ways to gain exposure to diverse assets, from traditional stocks to emerging cryptocurrencies. Among the myriad of investment tools, tracker certificates have emerged as a versatile and potent instrument. These securities, sometimes referred to as exchange-traded notes (ETNs), are gaining traction for their ability to provide a simple and cost-effective way to track the performance of an underlying asset or portfolio.

 

What Are Tracker Certificates?

A tracker certificate is a (formally) debt security issued by a financial institution whose value is designed to mirror the performance of an underlying asset or index. Instead of buying the asset directly, an investor buys a certificate that promises a return based on the asset’s price movements. The certificate’s value is directly tied to the performance of the underlying asset, whether it’s a single stock, a commodity, a market index, or a basket of assets. This “tracking” mechanism is what gives the instrument its name.

The issuer of the certificate (a financial institution or an SPV) holds the underlying assets or uses derivatives to replicate their performance. The certificates can then be listed on an exchange, providing liquidity and making them accessible to a wide range of investors.

Tracker certificates are typically issued in relation to an asset which is not so easily accessible to the wide market (or to a specific type of investors). It is doubtful that one would want to invest into Apple’s stock through a certificate fully following Apple while it is possible to buy Apple through any broker directly. This would create an unnecessary derivative layer between the investor and the ultimate investment and cause an extra fees/commissions expense. But trackers are a useful tool when investment is routed into a basket of securities, or a specific strategy, or a non-traditional asset. For example, investors that only use ‘real-world’ investment instruments but wish to have exposure to a crypto coin can easily attain their objective by buying a tracker (a security with ISIN) backed by the coin in question, without the need to get a crypto wallet, fund it and assume all the technical risks.

How Tracker Certificates Work

The mechanics are straightforward. The certificate’s value is calculated based on a pre-determined formula that links it to the price of the underlying asset. For example, a certificate tracking an index would move in tandem with the index’s price. If the index goes up by 5%, the certificate’s value will also increase by 5% (before fees).

Similarly to “actively managed certificates” (AMCs), one key feature of trackers is their ability to track actively managed portfolios. In this scenario, the underlying asset is a portfolio of financial instruments managed by a professional. The certificate tracks the net asset value (NAV) of this managed portfolio, allowing investors to gain exposure to professional expertise without investing directly in a traditional fund.

 

The Utility of Tracker Certificates

Tracker certificates offer several benefits that make them a valuable tool for both retail and institutional investors.

• Diversification: They provide a simple way to gain exposure to a wide range of assets, including those that might be difficult for individual investors to access directly, such as commodities, foreign market indices, or niche managed portfolios.
• Accessibility: By being listed on exchanges, they offer liquidity and ease of trading. An investor can buy or sell them throughout the trading day, unlike a traditional fund which might only be priced once a day.
• Cost-Effectiveness: Compared to actively managed funds, which often have high management fees, tracker certificates can be a more cost-effective option, especially those tracking passive indices. While they do have their own fees (management fees or issuance fees), these can be lower than those of a traditional mutual fund.
• Targeted Exposure: They allow investors to target specific investment themes or strategies. For instance, an investor bullish on the future of cryptocurrencies could buy a certificate tracking a portfolio of digital assets like Bitcoin and Ethereum. This provides a clean way to gain exposure to the sector without the complexities of direct crypto custody and security.

 

Risks and Considerations

While tracker certificates offer significant advantages, it is crucial to be aware of their risks.

• Credit Risk: Tracker certificates are unsecured debt obligations of the issuer. This means that in the event of the issuer’s bankruptcy, investors could lose their entire investment, regardless of the performance of the underlying asset. This is not very much of a risk in case the certificate is issued by a dedicated SPV (provided, it is managed properly), but can be a consideration if the issuer is a regular financial business entity, with many other risks to share. Even if ‘ring-fencing’ provisions are built into the issue terms of the certificates (i.e., stating that the assets which back the certificate are ring-fenced from the other assets of the issuer), having to deal with a bankruptcy may delay the return of the security’s value by years.
• Fully Backed or Not? The issuer of the tracker certificate is at liberty (unless the issue terms provide otherwise) to choose whether to actually buy the asset which is tracked by the certificate and securely hold it in the name of the issuer or dispense with that and instead buy a basked of derivatives instead, investing the remaining amount into something else. The rule of thumb is that the actual holding of the asset is always more secure than its value replication with derivative instruments. It always makes sense to inquire from the issuing company how they are planning to secure the exposure to the asset that they are planning to track.
• Tracking Error: Although designed to track the underlying asset’s performance, certificates may not perfectly replicate it due to fees, expenses, and the costs of hedging. This difference is known as tracking error.
• Liquidity Risk: While listed on an exchange, some certificates may have low trading volumes, making it difficult to buy or sell them at the desired price. This is particularly true for certificates tracking less common assets or niche portfolios. Investors should realize that a listing does not by itself ensure liquidity; most strategy-backed or non-traditional-asset-backed tracker certificates are listed on lowest level exchange platforms and markets, such as MTFs (multilateral trading facilities, in the EU terminology) where market-making and liquidity provision are not among the exchange’s requirements.
• Management Fees: The fees associated with tracker certificates can eat into returns over time, especially for actively managed certificates. It is essential to understand the fee structure before investing.

An Innovative Structuring Tool?

While most tracker certificates are created to pursue purely market objectives, that is, providing investors with a way to invest into an asset or a strategy, their legal structure makes them a handy structuring tool for personal assets.

Packaging a portfolio into the tracker certificate may provide enhanced privacy to the ultimate investor (i.e. a wealthy family office) and even offer tax benefits (depending on the specific tax law applicable, income on the assets packaged into the certificate may stay untaxed within the issuing SPV until its ultimate distribution). This is not unique for tracker certificates as a type of security, though: generally, imposing an intermediate SPV layer between the investor and the asset can serve the above-described purposes.