Exchange Traded Notes (ETNs) are similar to Exchange Traded Funds in that they trade on a stock exchange and track a benchmark index. However, there are important differences:
- An ETN is a senior, unsecured debt security issued by a bank, unlike an ETF which holds assets such as stocks, commodities, or currencies which are the basis of the price of the ETF.
- An ETN promises to pay at maturity, the full value of the index, minus the management fee. Like any other debt security, the investor is subject to the credit risk of the bank issuer.
ETNs were developed in 2006 by Barclays Bank to make it easier for retail investors to invest and maximize the returns in hard-to-access instruments, particularly in the commodity and currency areas.
By moving to a debt structure, Barclay’s eliminated the costs associated with holding commodities, currencies, and futures and improved the tax structure for investors.
An ETN is essentially a bet on the index’s direction guaranteed by an investment bank. As the index moves, so moves the ETN. The financial engineering underlying ETNs is similar to the financial engineering that investment banks have long used to create structured products for institutional clients.
ETNs were constructed to meet investor needs and have several advantages to consider:
Because ETNs don’t hold any portfolio securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN. ETN shares reflect the total return of the underlying index; the value of the dividends is incorporated into the index’s return but is not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs which regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. The short-term capital gains rate is equivalent to an individual’s ordinary income tax rate.
When the investor sells the ETN, the investor is subject to a long-term capital gains tax, currently 15%, but slated to rise to 20% in 2012. The taxable event occurs only when the investor sells the ETN. With conventional ETFs, a long-term holder would be subject to capital gains tax each year. The ability to significantly boost returns by escaping annual taxes on dividends is a huge benefit to ETNs.
Tracking Error Reduced
Theoretically, an ETF should give you the exact return of the index it tracks, minus the expense ratio. But sometimes the difference between the ETF and its index is larger than the expense ratio. This extra different between the portfolio’s return and the value of the index is called the tracking error.
Tracking error can be a significant issue for ETFs that are unable to hold all the components of a benchmark index, either because there are too many components and/or the components are illiquid. As a result, the value of the ETF and the value of the benchmark index may diverge. In contrast, the ETN issuer promises to pay the full value of the index, no matter what, minus the expense ratio, completely eliminating tracking error.
It should be noted that ETNs do have an underlying foundation. Typically, they are constructed of futures, options, stock swaps, and other instruments to approximate the benchmark index return. However, the underlying foundation is irrelevant to the investor; if the bank’s strategy fails to match the index, the bank is on the hook for paying off the rest of the gains to the investor.
ETNs brings the financial engineering technology of investment banks to the retail investor, providing access to markets and complex strategies that conventional retail investment products cannot achieve. For example, Barclays Banks in 2011 issued ETNs that allow investors to profit from increases in stock market volatility and another ETN that allows investors to profit from changes in the shape of the U.S. Treasury yield curve.
ETFs are subject to market risk, whereas ETNs are subject to both market risk and the credit risk of the investment bank issuing the ETN. Given the rapid implosion of the banking structure in the 2008 financial crisis, the credit risk issue should not be dismissed as irrelevant. Banks do collapse.
As described above, the ability to escape the short-term capital gains tax is one of the most compelling benefits to ETNs. It’s quite possible that the Internal Revenue Service may change the rules in a way that erodes the current benefit.
ETFs versus ETNs
The decision of whether to opt for an ETF or ETN in the same product area depends largely on your investment time frame. Given that ETFs are subject to yearly capital gain and income distributions which are taxable events to the holder – and ETNs are not – it seems reasonable to conclude that ETNs are a superior product for the long-term investor.
The irony is while ETNs offer tax advantages to long-term investors, the majority of ETNs offer access to more niche product areas that are not generally the recommended staple for long term investors. There are about 140 ETNs currently trading in the U.S. and most are in the areas of commodities, currencies, emerging markets, and specific strategies. An investor who wishes to diversify a core holding of stocks and bonds and gain exposure to these areas – for the long-term – might well consider ETNs because of the tax benefits.
For an investor who is looking at various commodities or emerging markets to take advantage of shorter term trends, there is little difference between ETFs and ETNs because the tax advantage is negated. In those circumstances, it’s generally a better to opt for the product with the most volume and liquidity in order to achieve the best transaction prices.