Following the popularity of Exchange Traded Funds (ETFs) product manufacturers developed Exchange Traded Notes (ETNs). Like ETFs these investments trade on a stock exchange and track the movement of an index, or sometimes an individual stock. But despite these shared features, and a similar sounding name, they are a very different type of investment. An Exchange Traded Note is an investment in debt, not equity. Also, they are regulated under the Securities Act of 1933, whereas ETFs are regulated by the Investment Company Act of 1940.
An ETN is simply a promise that the issuer will pay the investor according to the terms of the prospectus. There is no underlying portfolio of investments. This means that the investor is exposed counterparty risk. It wasn’t so long ago that some of the issuers, like Morgan Stanley, looked like they were going under, so this risk should not be discounted. The investor holds an unsecured promissory obligation, which is issued with the backing of a financial institution. The main difference between this and a bond is that instead of getting a fixed rate of interest, or a coupon, the investor’s return is linked to an index, or even a single stock.
Exchange Traded Notes have a fixed term, for example, iPath Dow Jones-AIG Commodity Index Total Return is an ETN which will pay a maturity equal to the gain on the Dow Jones-AIG Commodity Index when it matures on 12 June 2036. You could but an ETF to track the index, but because an ETN is not a fund it does not have to purchase any of the assets that make up the index, and by using derivatives it can actually track the index more accurately than an ETF. But the instruments that the issuer uses are irrelevant to the investor who has an unsecured guarantee that they will get a return with no tracking error. Some investors may consider that the counterparty risk is worth taking on in order to eliminate tracking error. However, once ETNs are listed they may trade at premiums or discounts to their indicative Net Asset Value (NAV).
ETNs can be treated differently from ETFs from a taxation standpoint. This varies depending on where you are domiciled, but in the US gains are treated as ordinary income if they are held for less than a year, and long term capital gains if they are held for a longer period. This also varies depending on the type of ETN, with the IRS considering single-currency ETNs as ordinary income regardless of hold period. [Note: ETNs are a relatively new product, their tax treatment is changing, and tax legislation regularly changes, so please consider these examples for discussion rather than accurate tax advice.]
One advantage of Exchange Traded Notes is that the issuers can base them on any index, even an obscure or exotic one, and in this way they can open up a wider range of products to the individual investor. An individual can now have an asset allocation strategy that includes commodities, foreign markets, and currencies. ETNs have provided access to hard-to-reach exposures, such as commodity futures and the Indian stock market. Certain asset classes and strategies are not easily accessible to individual investors. For example, the SPECTRUM Large Cap U.S. Sector Momentum Index, is designed to profit from the varied performances of the 10 sub-indexes of the S&P 500 Total Return IndexSM (SPTR) relative to each other and to the SPTR. This is not something that an ETF can track, but ETNs can provide exposure to this type of index. It is important that individuals understand that these are far more complex products than ETFs.
At the end of the 2009 Barclays Capital launched five Exchange Traded Notes giving investors long and short exposure to the S&P 500 index. Once the ETNs offers three times the performance of the S&P 500 based on a five year maturity, however, if the value of the ETN falls below $10 then it is terminated early. In the same month that these ETNs were launched in the US Barclays was also busy launching different ETNs in Singapore. The first Barclays ETN in Singapore was the iPath Dow Jones-UBS Commodity Index Total Return ETN, which gives retail and institutional investors a chance to gain exposure to a broad range of commodities during Asian trading hours. Barclays Capital’s head of investor solutions stated of ETNs, “They provide investors with simple, transparent, cost-efficient instruments that provide access to difficult-to-reach markets with the ease of trading through an exchange.”
If the rising popularity of ETFs is anything to go by then we can expect ETNs to rapidly gain popularity and gather billions of dollars of assets under management. However, it is important that investors understand that these products are a promise of index tracking, rather than the accumulation of assets in an attempt to replicate an index, and the underlying index is often more complex than those tracked by ETFs.
