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Are ETNs Right For Your Clients?

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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.

ETN Basics

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.

ETNs vs. ETFs

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.

Long/Short

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.

Due Diligence

Before deciding to invest in an ETN, try to locate an ETF that invests in the same market in order to compare benchmarks, fees and risks. The benefits of ETN investing need to be correctly balanced with the risks and clients’ objectives.

Here’s a quick ETN checklist of important factors that should help you to make the right choice:

Credit Risk: The creditworthiness of an ETN is itself not rated, but instead is based on the creditworthiness of the issuer. Put another way, the repayment of the principal and the interest (if any) and the payment of any returns at maturity or upon redemption are dependent on that issuer’s ability to pay.

Check the issuer’s credit rating and make sure you’re comfortable with the company’s financial stability and rating.

Redemption Risk: Some ETNs are callable at the issuer’s discretion. For instance, certain ETNs could have an early redemption or an accelerated maturity date based upon the issuer’s choice or certain market events that are triggered. If the note is called or redeemed at a price less than what the ETN investor paid, it could lead to a partial or total loss.

Conflicts of Interest Risk: ETN issuers will sometimes engage in behavior that is at odds with ETN shareholders. For example, some ETN issuers may lend out ETN shares to traders that engage in short selling against their own products. Check the ETN’s prospects under “conflicts of interest” to fully understand and evaluate whether these conflicts are worth the risk.

Price Tracking Error Risk: ETNs, like traditional ETFs, will generally trade at prices closely linked to their underlying indicative values. But this might not always be true. For instance, an ETN might trade at a premium to its indicative value if the issuer suspends issuance of new notes. Additionally, a decoupling between an ETN’s price and indicative value can occur during highly volatile markets or if the ETN issuer’s credit quality weakens.

Be sure to check an ETN’s market price against its indicative value and stay clear of notes that significantly veer from closing and intraday indicative values.

Taxation Risk: ETN issuers use the tax advantages of their products as part of their marketing pitch. Since ETNs aren’t required to make yearly income and capital gains distributions to shareholders, there is no annual tax due until the investor receives a gain by selling their note.

However, the tax advantages of ETNs aren’t guaranteed and the IRS has already ruled on currency ETNs that any interest paid to investors is taxable even if it’s reinvested and not paid out until the ETN holder makes a sale of the note. A similar future tax-adverse ruling by the IRS would wipe out the tax benefits of ETNs over other exchange-traded products. While no such ruling seems imminent, the possibility creates an element of significant uncertainty.

Summary

ETNs are complicated products that have many moving parts. Furthermore, the question of how to classify an ETN in the overall asset allocation of a portfolio is hugely debatable. Should the ETN holding be categorized as the asset class it proposes to track or as the fixed income instrument that it is?

By conducting due diligence and answering these tough questions, you will assure your clients that you’re putting their financial interests in first place. This approach will also help you to avoid major ETN pitfalls that routinely entrap the investing masses.

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