ETFs (exchange-traded funds) are a popular pathway to diversification because they expose investors to a wide range of financial assets, and come with lower expense ratios compared to mutual funds. But there’s another exchange-traded product that might appeal to the same kind of investor: an exchange-traded note, or ETN.
ETNs are debt securities that offer built-in diversity, along with solutions to some of ETFs’ more common problems, like tracking errors and short-term capital gains taxes.
Here is what any curious investor should know about ETNs.
What Is An ETN?
An ETN, or an exchange-traded note, is a debt security that acts much like a loan or a bond. Issuers like banks or other financial institutions sell the “note,” which tracks the performance of an underlying commodity or index benchmark.
ETNs do not yield dividends or interest in the way that ETFs do. Before investors can earn a profit from an ETN, they must hold the security long enough for it to mature — typically ten to thirty years. Upon maturity, the ETN pays out one lump sum according to their underlying commodity’s return.
Example of an ETN
Suppose you purchase an ETN that tracks the price of gold. As an investor, you don’t own physical gold, but the note’s value tracks gold’s performance. When you sell the ETN, during or at the end of the holding period, your return will be the difference between gold’s sale price at that time and its original purchase price, deducting any associated fees.
Pros of ETNs
ETNs are a newer financial security compared to some others available on the market. Their design comes with perks that some investors may find appealing.
Access to New Markets
Some individual investors may struggle to access niche markets like currencies, international markets, and commodity futures, since they require high minimum investments and significant commission prices. ETNs don’t have these limitations, making them more available to a larger pool of investors.
Accurate Performance Tracking
Unlike ETFs, ETNs don’t require rebalancing. That’s because ETNs do not own an underlying asset, rather they duplicate the index or asset class value it tracks. This means investors won’t miss any profits due to tracking errors, which means a difference between the market’s return and the ETF’s actual return.
Tax Treatment Advantages
Investors of ETNs don’t receive interest, monthly dividends, or annual capital gains distributions — which in turn means they don’t pay taxes on them. In fact, they only face long-term capital gains taxes when they sell or wait for an ETN to mature.
Liqudity
Investors have two options when selling ETNs: They can buy or sell them during regular day trading hours or redeem them from the issuing bank once a week.
Cons of ETN
Every investor must be wary of their investments’ drawbacks. Here are some potential cons of trading ETNs.
Limited Investment Options
Currently, there are fewer ETN options available to investors than other investment products. Additionally, though issuers try to keep valuations at a constant rate, pricing can vary widely depending on when you buy.
Liquidity Shortage
ETFs and stocks can be exchanged throughout the trading day according to price fluctuations. With ETNs, however, investors can only redeem large blocks of the security for their current underlying value once a week. This has the potential to leave them vulnerable to holding-period risks while waiting.
Credit, Default, and Redemption Risk
There are a range of risks associated with ETNs.
1. Risk of default. An ETN is tied to a financial institution such as a bank. It’s possible for that bank to issue an ETN but fail to pay back the principal after the holding period. If so, they’ll go into default, leaving you with a loss. There’s no absolute protection for owners in this case since ETNs are unsecured. External and social factors can lead to a default, too, not just economic influences.
2. Redemption risk. Investors can also take a loss if the institution calls its issued ETNs before maturity. This is called call or redemption risk. In this case, the early redemption may result in a lower sale price than the purchase price, leading to a loss.
3. Credit risk. The institution that issues the ETN impacts the credit rating of the security. If a bank experiences a drop in its credit rating, so will the ETN. That leads to a loss of value, regardless of the market index it tracks.
ETN vs. ETF: What’s the Difference?
Comparing ETNs and ETFs may help investors to see the pros and cons of either asset more clearly.
Both ETNs and ETFs are exchange-traded products (ETPs) that track the metrics of an underlying commodity they represent. After that, though, they operate differently from each other.
Asset Ownership
ETFs are similar to a mutual fund, in that investors have some ownership over multiple assets that the ETF bundles together. You invest in a fund that holds assets. They issue periodic dividends in returns as well.
In comparison, ETNs are debt instruments and represent one index or commodity. They are an unsecured debt note that tracks the performance of an asset but doesn’t actually hold the asset itself. As a result, they only issue one payout when you sell or redeem them.
Taxation
These differences impact taxation. An ETF’s distributions are taxable on a yearly basis. Every time a long-term holder of a conventional ETF receives a dividend, they face a short-term capital gains tax.
Comparatively, ETN’s one lump-sum incurs a single tax, making it beneficial for investors who want to minimize their annual taxes.
Recommended: ETF Trading & Investing Guide
The Takeaway
ETNs are unsecured debt notes that track an index or commodity, and are sold by banks and other financial institutions. Like any investment, ETNs have both benefits and drawbacks — and while they may sound like ETFs, there are differences between these two products, notably that with ETNs you do not own any underlying assets.
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