Investors historically have had short and bad memories. And although it’s been a few years since Lehman Brothers Opta ETNs (2008) went bust and the TVIX ETN blowup (2012), it’s worth revisiting the past to avoid future mistakes.
Although ETFs and exchange-traded notes (ETNs) are often grouped together because of similarities, there are significant product structure differences. This article will help you navigate—and explain to clients—these differences, and also provide an ETN due diligence checklist.
ETNs are debt instruments linked to the performance of a single commodity, currency or index.
They have a set maturity date and they do not usually pay an annual coupon or specified dividend rate. ETNs can be traded or redeemed before the maturity date. If the note is held to maturity, the investor is paid the return of the note’s underlying index, minus the annual expense ratio.
ETNs carry issuer risk which is tied to the creditworthiness of the financial institution backing the ETN. If the issuer’s financial condition deteriorates, it could negatively impact the value of the ETN, regardless of how its underlying index performs.
Gains on stock, bond and commodity ETNs are taxed at either long-term or short-term capital gains rates depending on how long the investor holds them. Typically, ETNs don’t distribute dividends or interest income, so they are very tax-efficient. In 2007, the IRS ruled that currency ETNs should be taxed as bonds, regardless of whether the interest inside the note is automatically reinvested and not paid out until the note holder sells the ETN.
ETFs and ETNs both offer intraday liquidity and will occasionally track the same benchmarks. However, there are some key differences.
Unlike traditional ETFs, exchange-traded notes are debt obligations backed by the financial or banking institution that issues them. ETNs pay a return linked to the performance of a single security or index.
With the exception of corporate bond ETFs that have a target maturity date, most ETFs do not have maturity dates whereas ETNs do.
Investors who choose to keep an ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. The annual fees deducted reduce the value of the payment. Maturity periods can vary and may be as long as 30 or 40 years. ETN investors who don’t want to hold their note until the maturity date may sell it prior to maturity in the secondary market.
While ETNs do track a variety of assets from bonds, stocks, commodities, and volatility, other notes will attempt to magnify long or short exposure to these same investing categories. These types of leveraged ETNs are best used as short-term trading instruments for tactical moves.
The DB Double Gold Short ETN (DZZ), for instance, aims for daily double inverse or opposite performance to gold bullion. That means if gold falls in value by 1% on any given trading day, DZZ should theoretically increase by 2%. Conversely, if gold rises 1%, DZZ should decline by 2%.
Although potential losses in a leveraged note won’t exceed a person’s investment, the extent of leverage used and the holding period an investor chooses will impact performance results.