What are the benefits and risks of investing in exchange-traded notes (ETNs) compared with ETFs.
In this podcast episode you’ll learn:
- What is an ETN.
- How big is the market for ETNs compared with ETFs.
- How ETNs can do a better job tracking their target index than ETFs.
- Why ETNs can be more tax-efficient than ETFs.
- How ETNs have counterparty risk, pricing risk, and liquidity risk.
- Under what circumstances would an ETN be preferred over an ETF.
Exchange-traded products (ETPs) have had a significant influence on market behavior over the past several decades, but the role of Exchange-Traded Notes (ETNs) is a bit puzzling—especially considering that there are only 165 exchange-traded notes of the 2,435 ETPs in the U.S. Both exchange-traded funds (ETFs) and ETNs fall under the heading of ETPs. While an ETF is a security that holds a basket of other securities such as stocks and bonds and is managed by a team of managers, an ETN is an unsecured debt security whose performance is tied directly to a specific financial index. Why exactly do ETNs exist when it seems there is so little use of them compared to ETFs? Are they something that investors should be considering for their portfolios? Listen to the episode to find out!
ETNs are tax-efficient have no tracking error
ETNs provide specific benefits not found with ETFs. David explains that exchange-traded notes often follow indices that ETFs do not, and because ETNs follow an index directly, there is the guarantee that its performance will match that of the index—eliminating tracking error. ETNs are also capable of following illiquid indices, while ETFs have a hard time doing so.
In addition to reducing the complex issues related to ETFs, ETNs are also much more tax efficient. Because ETNs have no distribution in the form of interest or dividends, the only tax required of the holder is capital gains tax. While the U.S. tax laws are always subject to change, ETNs are an efficient investment tool when it comes to simplifying your taxes.
ETNs also simplify tax filings for U.S. holders as they generate 1099s versus K1’s for holding specific issues such as Master Limited Partnerships. MLPs, which own energy infrastructure assets, are pass-through vehicles where taxes are paid by shareholders instead of by the MLP. ETFs and mutual funds are also pass-through vehicles. Regulators do not permit pass-through vehicles from owning large amounts of other pass-through vehicles. Thus they limit ETFs and funds to investing no more than 25% in MLPs unless the ETF or fund registers as a corporation and pays taxes.
ETN’s avoid this tax complexity even though they are also pass-through vehicles because they have no underlying holdings. They simply promise to pay the return of a specific benchmark, including benchmarks that track MLPs.
Be aware of the risks that come with exchange-traded notes
While ETNs obviously have specific benefits, they are unfortunately fraught with risks. The heaviest risk associated with exchange-traded notes is counterparty risk. As unsecured liabilities, ETNs are only as strong as their sponsors. If the bank or other issuing institution fails or goes bankrupt, an investor in the ETN could suffer significant losses due to non-payment.
Surprisingly, even though there is default risk with ETNs their prices do not reflect that by trading at a discount to their indicative note value. While investors can certainly research the risk associated with a specific ETN sponsor, even a small default risk should be reflected in the price. Instead, ETNs sometimes sell at a premium.
Exchange-traded notes also carry issuance and closure risks. Unlike ETFs, ETN sponsors can decide to stop issuing new ETN shares, which can lead the ETNs to sell at a premium to their indicative note value when demand is high.
Illiquidity risks and high fees are also concerns that investors need to be aware of regarding exchange-traded notes. Because the amount invested in ETNs is small with most ETNs having less than $50 million in assets, there can often be a large spread between what investors are actually buying and selling the ETNs for.
Understanding the purpose of ETNs in the world of ETFs and ETPs
With so many risks associated with ETNs, why do they exist at all? David explains that the important thing to realize with ETNs is that they are a niche product. Yes, the prospectus does take into account the many risks of ETNs, but there are also the benefits of exchange-traded notes not often found elsewhere. They are more tax-efficient than ETFs, provide exposure to areas of the market not tracked by ETFs and have very tight tracking error.
Listen to the episode for more details regarding how ETNs work and why you should or shouldn’t consider adding them to your portfolio!
- [0:21] ETPs, ETFs, and ETNs—which is the most popular?
- [3:10] Exchange-Traded Notes provide low tracking error.
- [5:28] ETNs are vastly more tax-efficient than ETFs.
- [6:14] Examples of Exchange Traded Notes.
- [10:16] Should there be a default-risk discount on ETNs?
- [13:34] Why there is issuance and closure risk with ETNs.
- [17:21] Clarification on the term “Net Asset Value” when referring to ETNs.
- [17:58] The issues of illiquidity risks and high fees.
- [20:46] Exchange Traded Notes are a niche product.
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 273. It’s titled, “What is an ETN? Understanding Exchange-Traded Notes.”
In a speech on September 8th, 2017, Michael S. Piwowar, Commissioner of the U.S. Securities and Exchange Commission stated “Exchange-traded products are among the most significant financial innovations in recent decades and have shaped financial markets as we know them today.” Exchange-traded products, or ETPs, include exchange-traded funds, ETFs for short, exchange-traded notes, or ETNs.
ETFs started wrapping up in the mid-1990s while the first U.S.-based ETN was introduced in 2006. An ETF is a security that holds a basket of underlying securities, such as stocks and bonds. It’s similar to open-end mutual funds with a professional money management team that oversees the portfolio, except that an ETF trades throughout the day on the stock exchange.
An ETN also trades on an exchange, but it’s an unsecured debt security, whose performance is tied to a specific financial index. It’s essentially a bond with a maturity date, usually 30 years or more, but unlike typical bonds it pays no interest. It just tracks a particular financial index. And so the value of this note increases or falls based on the performance of the specific index.
BlackRock does a quarterly review of exchange-traded products. In their second-quarter review, they showed that there are $5.6 trillion globally in exchange-traded products. That’s compared to $1.1 trillion in 2009. In the U.S. there are $4 trillion, in U.S.-sponsored exchange-traded products, that’s across 2,435 ETPs. That compares to $794 billion in 2009 where there were 925 ETP products.
So ETPs, they have been growing in popularity. But it’s mostly been ETFs. Of the 2,435 ETPs in the U.S. 2,314 are exchange-traded funded. 165 are exchange-traded notes. This is from the etfdb.com database. There’s only about $20 billion in assets in ETNs, compared to close to $4 trillion in U.S.-based ETFs.
Why do ETNs exist?
So that raises an interesting question: Why do ETNs exist? Well, there are two primary reasons to invest in an ETN vs. an ETF or an index mutual fund. First is to access products that don’t lend themselves to an ETF structure. Either due to tax issues, regularity issues, or complexity issues.
There’s an excellent paper by David A. Rakowski and Sara E. Shirley called, “What Drives the Market for Exchange-Traded Notes?” They found that 89% of ETNs track indices that are not covered by ETFs. They write, “The unsecured structure of ETNs allows them to track indices for which holding the underlying securities may be difficult or impossible while maintaining little to no tracking error before fees. This structure offers advantages for ETNs relative to ETFs in tracking indices based on abstract mathematical values, such as the Chicago Board Option Exchange Volatility Index or VIX, or in implementing leverage strategies.” That is strategies that employ debt.
They continue, “Investors, therefore, may find ETNs attractive either as a means to lower their costs of access to illiquid portfolios or as a way to obtain risk-return profiles that were not possible with existing securities.” ETNs will gain traction in areas that can’t be easily replicated by ETFs and they can do so with much lower tracking error.
Fidelity writes in a report on ETNs that, “tracking error can be a significant issues 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.”
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