Exchange traded notes, or ETNs, are similar to exchange traded funds (ETFs), in that they reflect the performance of an index; they have low expense ratios, high transparency and tax advantages. But they are structured a bit differently.
The first ETN products were launched in 2006 by Barclay’s Bank and marketed as iPath ETNs. They promised to provide investors access to difficult to own markets, but now, more ETNs are created to offer specialized and more innovative investment products across various asset classes. [Reasons to Consider ETNs]
What Makes An ETF So Different?
ETNs are structured products issued as an unsecured, unsubordinated senior debt note by an issuer or bank. The ETN investment depends on the financial well-being of the issuer. Reputable ETN issuers, like Barclays, Credit Suisse and UBS, may command strong credit ratings, but who is to say that their credit risk might not rise in the future?
ETNs have maturity dates, unlike ETFs. The ETNs are long-term, unsecured notes that generally hold a 30-year life span. If an ETN is held until the debt matures, the investor will receive a payout based on the principal payment as calculated by the performance between the related index minus fees calculated as a percentage of the ETN’s value. The ETN issuer does not make the payments until maturity or redemption of the note.
Like ETFs, ETNs are traded on a major exchange during regular trading hours and they track the performance of an underlying index. An investor purchases shares of the ETN and the issuer agrees to pay the investor a dollar amount tied to the performance of the specified benchmark minus fees at the end of the note’s term. While ETFs actually hold ownership over underlying investments, ETNs provide returns based on a notional ownership of the investments tracked – ETNs essentially provide investors access to a market or investment strategy without actually owning the underlying assets. In exchange, investors get the chance to gain exposure to markets or investment opportunities that are otherwise unobtainable through direct ownership.
Potential Risks
Since ETNs are considered debt instruments and the value of an ETN is based on the movements of the related index, ETNs will not have tracking errors.
However, ETN investors are exposed to credit risk. For instance, if an ETF fund sponsor goes bankrupt, investors would still have a claim on the underlying securities or stocks the ETF invested in. In comparison, if an ETN issuer goes bankrupt, investors may lose their principal, since the ETN sponsor does not have to hold the underlying assets related to the ETN’s returns – there are no pledged assets that serve as collateral. Additionally, ETN investors are subject to counter-party risk – any downgrades on the issuer’s credit rating can negatively affect the ETN, even if the fundamentals are on the side of the ETN.