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.
Taxes
The way taxes on ETNs are treated is one of the greatest advantages ETNs have over mutual funds, and to some degree even ETFs.
Investors can look at ETNs as a kind of prepaid forward contract. An ETN issuer will basically pay the note holder a dollar amount equal to the value of the benchmark at some agreed-upon future date. As a result, potential returns received from the difference between the sale of the ETN and the purchase of the ETN will be categorized as capital gains or loss upon the sale, redemption or maturity of the note. Consequently, ETN investors may defer the recognition of income until the contract matures and eliminate ordinary interest income factor that comes with normal debt contracts.
Foreign-currency ETNs, or foreign-currency –based prepaid forward contracts, are taxed as debt for U.S. tax purposes. Accordingly, amounts repaid to a currency ETN investor would be equal to the change in the foreign currency exchange rate, plus interest, minus fees. Foreign-currency ETNs are treated as debt instruments, and the revenue ruling does not mention other ETNs, like those linked to commodities or stocks. Currently, the government is requesting public comments on the proper tax treatment of all ETNs.
ETNs are more commonly used in investment portfolios with a long-term time horizons due to its capital gains treatment. The capital gains are deferred until the securities the ETN holds either matures or the ETN is sold. It should also be noted that ETNs do not offer distributions.
The Internal Revenue Code can be pretty tricky and complicated, and for this reason we suggest consulting a tax advisor, as we are not accountants and this should not be construed as tax advice.
The ETN Biz
There are currently around 135 ETNs with total assets under management of about $16 billion, as provided by PowerShares, iPath, UBS, ELEMENTS, Barclays, Market Vectors, JP Morgan, Credit Suisse, Claymore, Goldman Sachs and VelocityShares. The ETN products cover a lot of aspects of the marketplace, including equities, bonds, commodities, foreign economies and sectors, among other asset classes. In addition, leveraged/inverse ETNs are available for those who want to implement specific fund strategies.