After five consecutive yearly gains, the global equity market has more than recovered. Credit markets, with the exception of isolated places like Argentina, are healing. And the appetite for risk taking has returned.
The collapse of exotic financial products like credit default swaps (CDS), collateralized debt obligations (CDOs) and auction rate securities (ARS) is a distant memory. What about exchange-traded notes or ETNs? Now that financial markets have risen, are they any safer?
ETNs, unlike their ETF cousins, are unsecured debt instruments that pay a return linked to the performance of an index, a currency or a single commodity. Similar to bonds, ETN payments rely on the full credit and faith of the entity backing the product. Many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years.
The value of ETNs is primarily determined by two factors: (1) the performance of their underlying index or asset, and (2) the creditworthiness of the issuer.
Pros and Cons
One of the biggest advantages of ETNs is how they’ve opened the alternative asset class universe, giving investors more opportunities to diversify and make tactical investment choices. ETNs offer exposure to a variety of markets such as commodities, single-country currencies and sovereign debt.
Other ETNs track narrow indexes with leverage and shorting strategies. Examples of this include the PowerShares DB Gold Double Short ETN (DZZ), the PowerShares DB Crude Oil Double Short ETN (DTO) and the PowerShares DB Agriculture Double Short ETN (AGA).
Another plus for ETN shareholders is zero tracking error. This is because an ETN issuer promises to give the shareholder a performance return that is identical to the underlying benchmark minus fees. As a result, ETNs don’t suffer from index return to actual fund return discrepancies common to both mutual funds and ETFs.
The biggest shortcomings of ETNs are credit risk and taxation. It’s important that advisors weigh these disadvantages against their advantages in order to make the right choice for clients.
While ETNs are touted for their tax efficiency over mutual funds or ETFs, the truth is not all types of notes are taxed the same. For instance, commodity ETNs are taxed at the same capital gains rate as the commodity futures they use are when the futures are rolled. On the other hand, currency-linked ETNs are taxed as debt instruments.
Furthermore, the IRS has yet to give its opinion about the taxation of stock and bond ETNs. Currently, these types of ETNs have no annual tax because there is no interest or dividend distributions made. A capital gain (or loss) is realized when shareholders sell their notes or hold them to maturity.
“While there have been several opinions issued by law and accounting firms related to ETNs, we have not seen a definitive statement from the IRS regarding ETNs’ tax treatment,” states Andrew Clark, manager of alternative investment research at Lipper. “Most prospectuses acknowledge the uncertainty surrounding the tax treatment of ETNs.” How much damage would a negative tax ruling by the IRS be on the ETN market?