Exchange Traded Notes (ETNs)

What are they and how do they work?

Exchange Traded Notes (ETN) are sometimes referred to as ETFs. ETNs, however, differ from ETFs in that the underlying holding of the ETN is a note or debt obligation that promises to mimic the return of the underlying index it attempts to track, minus fees, while an ETF consists of a basket of securities. While the ETN structure is often used for currency and commodity exposure or other non traditional market indexes such as those focused on volatility. It's important to mention that in addition to the already stated risks of that exchange traded products have, ETNs also carry additional "issuer risk" (sometimes referred to as counter-party risk) of the entity that issues the note, so that if the issuer of the note becomes insolvent, for example, the ETN will lose value or become worthless. Also, there are ETNs that are designed to return a multiple of its benchmark index's performance (or inverse of performance) over a specific, pre-set time period, and these ETNs carry the same risks as leveraged or inverse ETFs.

What are some of the Features of ETNs?

As with Exchange Traded Funds, investors often use an ETN to gain exposure to a particular market, commodity, currency, or other "difficult to access" region or sector. ETNs are designed to provide investors a return that corresponds to a particular index return, minus the ETN's fees. Generally, like ETFs, ETNs are a transparent, cost effective way to access market segments using an exchange traded vehicle. Investors may choose to use ETNs for portfolio diversification, to assist in the tax management of their portfolio through timing the sale of their ETN (e.g. tax loss harvesting), or even choose to short the ETN through their brokerage account. Investors might choose to utilize an ETN if:

What are some of the Risks of ETNs

Because an ETN is comprised of debt obligations from the issuer, and there is no basket of securities to serve as collateral as with ETFs, ETNs carry significant credit, or counterparty, risk. Therefore, assessing the creditworthiness of the issuer should be part of an investor's analysis in determining whether an ETN is a suitable investment for them. For example, if the issuer of the underlying note that makes up the ETN should file for bankruptcy, the ETN can lose value, and may even become worthless. The shareholder of the ETN would be considered a note holder to the issuer, and would be eligible for payment based on the capital structure of the issuer. In fact, in addition to the underlying index the ETN seeks track, the creditworthiness of the issuer can be an important element to the valuation of the ETN, and a likely cause for any premium or discount an ETN may develop based on supply and demand elements associated with how investors view the ETN and the creditworthiness of the underlying sponsor of the notes that comprise the ETN. The tax treatment of ETNs also differs. The IRS has clarified the rules for single country currency funds (accrued interest is taxable to the investor during the time the investor owns the ETN, even if the investor has not sold the ETN). Any specific tax nuances for other types of ETNs such as commodity are less clear, and are currently being evaluated by the IRS.** Note that leveraged and inverse ETNs carry additional risks, as described in their prospectuses, and outlined below.