In mid 2006, the exchange traded fund (ETF) world welcomed the birth of their new cousin, the exchange traded note (ETN). The exchanged traded note is the brainchild of Barclays Bank, the inventor of the exchange traded fund. Since the launch of the exchange traded note in 2006, there have been numerous new ETNs brought to market from many large banks. Do you know if you own an ETF or ETN? On the surface, they can look like very similar products, but as you look closer they start to look more like distant cousins rather than first cousins. Let’s take a closer look into the new world of exchange traded notes.
ETNs are senior, unsecured, unsubordinated debt securities issued by a bank. Like other debt issues, they have a maturity date and are backed by the credit of the issuing bank. ETNs are not equities or indexes; however, these products are designed to perfectly track an index (i.e. without tracking error). The issuing bank promises to pay the exact return minus investor fee of the index it is attempting to track. The notes can be traded daily on an exchange just like ETFs.
Exchanged traded notes were designed to eliminate the tracking error issue that plagues ETFs and indexed mutual funds. This tracking error is the difference in the actual return of an index vs. the gross return of the investment vehicle attempting to replicate the index results. For example, you cannot invest in the S&P 500 Index, as it is not a security. If you wanted to track the performance of the S&P 500 Index, you can take several approaches. The first approach would be to buy all 500 stocks that make up the S&P 500, in the exact quantities of the index weight, and at the exact price the index is using. This would be a very expensive task with commission and bid/ask spreads, i.e. trading costs. It is highly unlikely an index can be replicated by the average investor, since the index does not have to pay taxes or fees. You could, however, buy an ETF or index fund that attempts to mirror the S&P 500. Most ETF or index funds do not buy all 500 stocks. They use sophisticated statistical sampling models that they believe will allow them to represent the S&P 500 without purchasing all 500 stocks. If they sample correctly, they should be able to closely represent the return of the fictitious S&P 500 investment. It is highly unlikely that they will perfectly mirror the returns, thus creating the tracking error dilemma. ETNs do not have to purchase the underlying assets, because the issuing bank promises to pay the index return. Therefore, ETNs do not have a tracking error problem.
ETNs do not pay interest or dividends, so they may offer an additional tax benefit that ETFs do not have. Since the ETN owns no underlying assets, the interest and dividends that are normally paid to investors of ETFs or mutual funds get rolled back into the index’s value. This has the effect of turning all income into capital gain/loss income and is not taxable until you sell the ETN, redeem it, or it matures. The IRS has made a few exceptions to this benefit, which generally apply to the treatment of gains and losses for ETNs tracking currencies. The IRS is still reviewing how they will treat gains and losses of non-currency ETNs, so check with your tax adviser before you invest.
ETNs, just like their cousins, are traded daily on a exchange. You can buy and sell these securities like a stock. However, because they are new and unique, they may be less liquid than other securities. Once each week, large institutional investors can redeem large blocks of the ETN for the current underlying value, less investor fees, directly with the issuing bank for cash. This feature helps keep the premium/discount pricing of the ETN close to the underlying value of the index.
The major disadvantage of ETNs is the element of credit risk they bring to the table. Since these are promises from the issuing bank and are not back by underlying securities, the solvency of the issuing bank can have a material impact on the ETN’s trading value. With this credit risk, it is possible to have the underlying index increase in value, while the trading value of the ETN decreases in value. ETNs are exposed to both market risk and credit risk unlike ETFs, which are only exposed to market risk. ETNs currently do not offer any principal protection.
In closing, exchanged traded notes have some potential to be attractive investments—especially, in tracking indexes that are difficult or costly to track with exchange traded funds or mutual funds. These are still very new investment vehicles and do not have a long history of performance. Since the IRS has yet to rule on the income treatment of non-currency related ETNs, one of the ETNs benefits (i.e., tax deferral and capital gain treatment) is still uncertain. On the surface these investment vehicles can look like exchange traded funds, but as you can see, they have more risk than an ETF. You should be careful you know what you are buying. If you have questions on your investments, give the experts at Henssler Financial a call at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
