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Exchange-Traded Notes: The Facts and the Risks

Key Points
  • Exchange-traded notes (ETNs) are not exchange-traded funds (ETFs)

  • ETNs have characteristics and risks which are different from ETFs

  • ETN risks may be increasing for investors due to changes in the regulatory environment for issuers

Exchange-traded funds (ETFs) have been around since 1993, and there’s no doubt that they are popular with investors. Exchange-traded notes (ETNs) may have a similar sounding name, but ETNs are not the same as ETFs, and they carry some important risks to be aware of.

ETF, ETN, ETP—what does it all mean?

While ETNs are sometimes grouped alongside ETFs, the big umbrella term that covers both of them is ETP: exchange-traded product.

An exchange-traded fund (ETF) is a basket of securities such as stocks, bonds or commodities. It's similar in many ways to a mutual fund, but it trades on an exchange like a stock. An important characteristic of ETFs and mutual funds is that they're legally separate from the company that manages them. They're structured as separate "investment companies," "limited partnerships" or "trusts." This matters because even if the parent company behind the ETF goes out of the business, the assets of the ETF itself are completely separate and investors will still own the assets held by the fund.

Exchange-traded notes (ETNs) are different. Instead of being an independent pool of securities, an ETN is a bond issued by a financial institution. That company promises to pay ETN holders the return on some index over a certain period of time and return the principal of the investment at maturity. However, if something happens to that company (such as bankruptcy) and it's unable to make good on its promise to pay, ETN holders could be left with a worthless investment or an investment that is worth much less (just like anyone who had lent the company money).

Why would anyone buy an ETN?

Given that ETNs carry credit risk, you might wonder why anyone uses them at all. But there are a few features that attract some investors to ETNs.

First, since the issuer is promising to pay exactly the return on some index (minus its own expenses, of course), there's little risk of tracking error. That is, the ETN should be expected to very closely match the performance of the index. Of course, well-managed ETFs can do the same thing, but an ETN comes with an explicit promise.

Second, some ETNs promise to deliver the returns of a particular index that isn't available in an ETF framework. For investors committed to such a niche investment, an ETN might be the only option.

Third, ETNs may have some attractive tax consequences. While this could change in the future, ETN investors are usually responsible for paying taxes on their investment only when they sell it for a gain. ETNs don't distribute dividend or interest income the way a stock or bond fund may, so all taxes are deferred and taxed as capital gains. It's important to note, however, that the IRS has ruled against this tax treatment for currency ETNs, and similar rulings may follow in the future for other types of ETNs.

What are the risks?

Credit risk: ETNs rely on the credit worthiness of their issuers, just like unsecured bonds. If the issuer defaults, an ETN’s investors may receive only pennies on the dollar or nothing at all, and investors should remember that credit risk can change quickly. At the time of its bankruptcy in September 2008, Lehman Brothers had 3 ETNs outstanding. While many investors sold these ETNs prior to Lehman’s collapse (only $14.5 million remained in the 3 ETNs when the firm folded), investors who didn’t get out received just pennies on the dollar.

Liquidity risk: The trading activity of ETNs varies widely. For ETNs with very low trading activity, bid-ask spreads can be exceptionally wide.  For example, in Q3 2016 one ETN had an average spread of 39.8%! 

Issuance risk (aka volatile premiums): Unlike ETFs where the supply of shares outstanding fluctuates in response to investor demand, the supply of ETNs is controlled entirely by their issuers. As another example of what could go wrong with an ETN, consider one highly exotic ETN (TVIX) that was designed to track twice the daily returns of an index of futures contracts on the implied volatility of the S&P 500® Index. On February 21, 2012, the underwriting bank behind the note decided to stop issuing new shares of the ETN. This meant that as more investors tried to buy the note supply wasn’t keeping up with demand, and the note’s price began increasing by much more than its indicative value. By March 21, the ETN's market price was almost 90% higher than its underlying indicative value. On March 22, when the underwriting bank announced that it would once again start issuing new shares, the ETN's price began its steep descent back to reality. The ETN's price plunged almost 30% in one day and almost 30% again the next day, ending the two-day stretch with a price only 7% higher than the fund's indicative value.

Closure risk: There are multiple ways for an issuer to effectively close an ETN. An issuer may call the note (also known as“accelerated redemption”) by returning the value of the note less fees. However, not all ETNs have terms which allow for accelerated redemption.  A much less friendly alternative is for issuers to delist the note from national exchanges and suspend new issuance.  When this happens, ETN investors are left with a pretty unpleasant choice. They can either hold the note until it matures, which could be up to 40 years away, or trade the ETN in the over-the-counter (OTC) market where spreads can be even wider than on national exchanges. Recognizing the problem this may create for investors, some issuers have attempted to create a more note-holder friendly alternative by offering to buy back ETNs directly through tender offers.

Is it worth the risk?

For many years, we’ve felt that the credit risk inherent in an ETN isn't worth it. Most investors turn to exchange-traded products in order to get exposure to a particular segment of the market, not to evaluate a bond issuer's health. As a result, they generally will not find ETNs to fit their investment goals.

More recently, we’ve also come to believe that market conditions for ETN issuers may make issuance risk and closure risk equally as serious. ETNs are issued by large banks which are regulated by the Federal Reserve and the Financial Stability Board.  These regulators are concerned about the nature of the liabilities that ETNs create on the balance sheets of their bank issuers.  As a result, sponsoring ETNs is expected to become much less profitable for banks in the coming years which could lead to higher issuance and closure risk for ETN investors.

Bottom line

If you still think an ETN might make sense for your portfolio, we encourage you to first check out an alert issued in July 2012 by The Financial Industry Regulatory Authority (FINRA) to inform investors of the features and risks of ETNs: "Exchange-Traded Notes—Avoid Unpleasant Surprises" ( ).

Data Source: Morningstar Direct, ArcaVision


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