ETN stands for an Exchange Traded Note and should not be confused with an ETF. It shares some attributes of Index Funds and Equities but differs from them significantly.
ETN is really a debt instrument and not an equity instrument, and that is what makes it different from ETFs and Index Funds. ETNs are issued by banks or other financial institutions and are a relatively new phenomenon. The first ETN was issued by Barclays Bank in 2006.
ETNs track an underlying asset and right now there are four type of ETNs:
- Currency
- Commodity
- Emerging Market
- Strategies
Despite being a debt instrument; ETNs do not offer capital protection. Neither do they make any interest payments till maturity. Instead they track the price of the underlying asset. The redemption price that you pay depends on the price of the underlying asset.
There are two factors that impact the price of an ETN:
- The price of the underlying asset
- The credit rating of the issuing bank or financial institution
Since it is a debt instrument, the credit ratings make a difference in the valuation of the ETN. So the asset price may go up but the value of your ETN may still go down if the credit rating of the issuer is hit.
ETNs fall under the category of unsecured debt so the impact of credit ratings get accentuated on their price. Also, ETNs track an asset price but they don’t actually go out and buy the asset itself like ETFs.
We talked about the differences, let’s look at some similarities between ETFs and ETNs now:
- Both can be bought and sold in a stock exchange
- Both track the price of an underlying asset
Tax Implication
The most important reason for the popularity of ETNs is their tax treatment. They are treated as prepaid agreements and as a result the gains from an ETN is taxed only at maturity.
On the other hand, the dividends from an ETF or the gains at the time of rollover are taxable at every instance.
This has been the primary reason for the growing popularity of ETNs.
Risks
There are two type of market risks that an ETN faces. One is the movement in the underlying asset prices. So an ETN that tracks oil prices will go down if oil prices were to go down.
The second market risk is the solvency of the issuer itself. If the bank which issued the ETN were to go down, then the ETN will be worthless too. This risk is absent in ETFs.
Then there is the question of liquidity. ETNs are relatively new and much smaller in size than ETFs. This poses some liquidity questions.
Conclusion
If you were to select between an ETN and ETF tracking the same asset, you need to consider two factors to make your decision.
- Your tax bracket and whether you are a long or short term investor
- The risk that the issuing bank carries
The last thing to keep in mind is that when you are buying an ETF, you are buying real assets, but when you buy an ETN, you are essentially buying a “promise by the bearer of the note”, since it is a debt instrument.