What is an ETN?

Since the first exchange-traded note (ETN) was launched in 2006, these investments haven’t exploded in popularity the same way as exchange-traded funds (ETFs). Still, ETNs control billions in assets, and they offer investors a way to get exposure to bond-like investments that have some features similar to stocks and ETFs.

Here’s what you need to know about ETNs.

What is an ETN?

ETNs and ETFs are types of exchange-traded products (ETPs). Like a bond, an ETN is a type of debt investment. Essentially, an institution or bank sponsoring an ETN promises to tie the amount of the investment to an underlying asset or index and will pay the investor back the amount the ETN is worth when it matures. Investors receive an amount equal to the value of the underlying asset, minus any fees, upon the ETN’s maturity.

With a bond, the investment amount goes to the company repaying the loan. With an ETN, the borrower is a financial institution, such as a bank. While bonds pay interest or dividends to the investor, an ETN investor generally does not receive interest. But like stocks and ETFs, the investor has the option of trading an ETN on a secondary exchange before it reaches maturity.

How do ETNs work?

An ETN is a debt instrument and does not represent ownership of the underlying asset or index. The investor does not own shares of any company or asset, but instead owns the debt of a financial institution. The return on an ETN relies on the institution’s promise to repay based on the underlying asset’s performance.

The amount of money invested in an ETN is tied to a specific index or asset. When the ETN matures, the investor receives back the value of the underlying asset, minus any fees. Profit is earned if the underlying asset or index has increased in value since the investor’s initial purchase. If the underlying asset loses value, the investor can lose money.

The price of ETNs fluctuates like those of stocks. Like stocks, ETNs can be bought and sold on major exchanges. This means an investor can decide when to buy or sell ETNs, rather than waiting for a maturity date.

ETNs vs. ETFs

ETNs and ETFs are tied to an underlying index or asset, and can be traded like stocks. Additionally, both were developed specifically to generally have lower expense ratios compared to actively managed mutual funds. However, there are several differences (see table below).

In addition, ETFs have tracking error, while ETNs do not. This is because an ETN investor does not own any shares of the underlying asset. Tracking error occurs when an ETF, mutual fund, or index fund differs in performance from the corresponding benchmark. Tracking error could mean the ETF performs better or worse to some degree than the benchmark.

Recall that investing in an ETN means loaning money to a financial institution that promises to pay it back based on the performance of the index. Consequently, the return will be directly pegged to the value of the index. However, that also means your investment is vulnerable to the credit risk of the issuer.

Investing in ETNs

There are a number of reasons why investors might consider investing in ETNs. In addition to accessing debt investments with the trading features of stocks and ETFs, as well as the reduced risk of tracking error relative to ETFs, these include:

• Potential tax benefits: Since ETNs generally do not pay periodic dividends, investors only owe taxes when either the ETN matures or they sell the ETN on the exchange. This means all gains are taxed as long-term capital gains, which has a lower rate than short-term capital gains that may be applicable to some other investments if they are sold within a year from purchase.
• Strategy and market access: Retail investors may not have access to all markets and strategies using traditional investments. ETNs can allow investors to take advantage of some strategies that they may not have otherwise been able to.

Risks of ETNs

Though ETNs can offer a number of benefits to investors, they are not without risks. As previously mentioned, a primary difference between ETFs and ETNs is the credit risk of the institution who has promised to repay the performance of the ETN. Additionally, ETN investors should consider: 

• Liquidity risk: ETNs can trade on the major exchanges, but that does not necessarily mean there is a secondary market for them. Investors could find it difficult to cash in certain ETNs with low liquidity.
• Volatility risk: Since ETNs do not pay dividends, the only way to make a return on your investment is if the underlying asset is worth more at maturity (or when you sell your ETN) than it was at the time of purchase. As a result, returns could be more volatile relative to some other types of investments without the smoothing effect of dividends.
• Closure risk: ETNs can be both called (like a bond) and could be delisted from the national exchange to trade OTC, which would mean they trade with wider spreads.
• Price deviation risk: An ETN’s closing indicative value, as well as its intraday indicative value, are distinct from an ETN’s market price, which is the price at which an ETN trades in the secondary market.

How to buy ETNs

Investors can purchase ETNs directly from an issuing bank or through an online broker. Financial institutions commonly issue ETNs at $50 per share, and the price of an ETN on the secondary market can depend on the value of the underlying asset or index. If you are considering an ETN, think about the following questions: 

1. How will an ETN help you meet your investment objectives? 
2. Do you understand and have an outlook for the underlying asset or index tied to the ETN? 
3. Can you afford to lose the investment if the issuer defaults? 
4. Is an ETN your best option for tax-efficient investing?

If investing in an ETN might make sense for you, there are hundreds of options for you to choose from.