ETNs combine a bond's reliability with a stock's profitability. Here's how they work, and how to weigh the risks and rewards
- Exchange-traded notes (ETNs) are debt securities that track the performance of a financial asset or index and trade on stock exchanges.
- ETNs pay a lump sum when they mature, and investors make money if the underlying tracked asset has risen in value.
- While they offer investors access to exotic sectors and strategies, ETNs have drawbacks, like illiquidity and credit risk.
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Many investors are likely familiar with the exchange-traded fund (ETF), a bundle of easily-traded securities ideally suited for portfolio diversification. But what is an exchange-traded note, or an ETN? Is it the same as an ETF?
The short answer is that the two products are quite different.
An ETF operates like a mutual fund, giving investors a tiny slice of ownership in each of the bundled assets it represents, while an ETN is a debt instrument most similar to a corporate bond.
ETNs come with unique risks that are tempered by benefits like exposure to novel markets and favorable taxation, so they're well worth exploring.
What is an ETN?
"Exchange-traded" means that ETNs are bought and sold on a national stock exchange, while "note" is a nod to the fact that an ETN is actually a debt. Much like a bond, a note is an IOU from a bank or other financial institution, indicating your purchase, and lining you up for a potential payout when it matures. ETN investors don't own anything; rather, they hold this debt.
Without ownership shares, that payout can't come in the form of dividends, so where does it come from?
An ETN is modeled to track a specific market metric (a measure), and your return will be based on its performance. If that metric — it can be a particular asset, asset class, or an index — is higher when your note matures than it was when you purchased it, you make a profit, and vice versa.
Take an ETN that models the price of gold, for example. You don't actually own any gold bars, but the value of your note is pegged to gold's price. The difference between the purchase price and the sale price of the underlying commodity is your return — minus any fees.
How does an ETN work?
As we previously mentioned, an ETN is a debt security, a financial asset representing a loan one party makes to another. One party (who buys the security) provides liquid capital, and the other (who issues the security) offers favorable terms for getting to use that capital, dictating term length, repayment of the principal, and often a set return.
The catch is that for ETNs, everything except term length is unknown, as its success or failure is bound to the performance of the asset. Plus, the debt you're taking on is unsecured — there's no collateral to back it — which means you're staking everything on the promise of the borrower.
At term's end, you'll be issued a lump-sum payout consisting of your initial principal, plus or minus the price change for the underlying asset.
ETNs vs. ETFs
Since ETNs are so often discussed in the same breath as ETFs, it's useful to compare the two assets. Both are exchange-traded products (ETPs), and both track the movements of the metric they represent. But from there, ETFs and ETNs differ in three crucial ways:
1. Format: An ETF is built like a mutual fund and issues returns as periodic dividends, whereas an ETN is a debt instrument and issues returns as a single payout.
2. Risk: A successful ETF will perform identically to its tracked index or asset, but not every ETF is successful. Deviations are known as tracking errors and eat into returns. For ETNs, tracking errors aren't a factor, since they are tied directly to their tracked metric.
3. Taxation: Your ETF distributes taxable dividends based on your ownership shares. Because ETNs issue lump-sum payments, note-holders pay taxes just once.
What are the benefits of an ETN?
The ETN was designed to provide the reliability of a bond with the profit margin of a stock and come with a whole host of additional benefits.
Favorable tax treatment
Because ETNs don't distribute dividends, many note-holders escape short-term capital gains taxes. You'd only owe taxes on any profits when the note comes due or you sell it, and that'll usually be at the lower long-term capital gains rate.
Access to novel markets
ETNs give access to complex strategies and sectors of the market that are often difficult, if not downright impossible, for individual investors to reach, like foreign markets, currencies, and commodity futures.
More accurate returns
Since ETNs rack their associated metrics point for point, you won't miss out on profits due to funds' underperformance, expense ratios, or tracking errors.
Potentially enhanced returns
A leveraged ETN — which uses financial derivatives and hedging techniques — can offer even greater returns. Think of it as a multiplier. While a regular ETN typically tracks its underlying index on a one-to-one basis, a leveraged ETF may aim for a two-to-one or even three-to-one ratio. That means, if the value of the underlying commodity increases by 1%, your return increases by 2% with a leveraged ETN. But note: those same rules also apply to losses.
What are the risks of an ETN?
No investment product is without its downsides, so there are some reasons to be cautious about ETNs as well.
Every trade you make exposes you to market risk (the chance that the asset won't perform well). But ETNs come with credit risk as well: If the issuing institution defaults, your principal and return go with it. Short of that, even bad news about the issuer could ding the price of its ETN, impacting you if you wanted to sell it before maturity.
Lack of liquidity
ETFs can be traded throughout the day, allowing the nimble investor to take advantage of market movement, but the ETN is less liquid. Those hoping to jettison large blocks of units get the opportunity to do so just once a week, leaving you exposed to holding-period risk in the meantime.
Fewer investment options
ETNs are less in-demand than many other products, so options remain limited and prices can vary wildly. The issuing institutions do their best to keep valuations stable, but their methods can cause fluctuation.
The financial takeaway
If this sounds a bit too risky, there are other non-ETN options to explore. A good place to start is with bond ETFs or bonds themselves, which guarantee a fixed rate of return in advance. Unlike ETNs, bonds are rated by credit agencies, which indicates how big a risk they are.
Or, if your interest is still piqued by ETNs, think about what asset classes are currently missing from your portfolio, and look for a note that tracks them. Once you've found one you like, observe how it's behaved over time, mark the reputation and stability of the issuing bank, and make sure you understand exactly what each note and its underlying asset contains.
Then and only then should you take note to add that particular exchange-traded note to your portfolio.
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