Is ETN a Good Investment? Everything you Need to Know

Is ETN a Good Investment
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Many investors have heard of an ETF (Exchange-Traded Fund), which is a collection of easily traded securities that is good for portfolio diversification. But what exactly is an ETN (Exchange-Traded Note)? Is it the same as an exchange-traded fund (ETF)? and is ETN a good investment?

The short explanation is that the two items are extremely dissimilar.

An ETF works similarly to a mutual fund, offering investors a small stake in each of the bundled assets it represents, whereas an ETN is a debt product comparable to a corporate bond.

ETNs have distinct risks that are mitigated by benefits such as exposure to new markets and reduced taxation, so they’re worth investigating. In this article you will understand what an ETN is, its benefits and risks, so as to answer the question ”Is ETN a good investment?”

What is an ETF (Exchange-Traded Fund)?

A basket of securities, such as stocks, bonds, or commodities, makes up an exchange-traded fund (ETF). It’s comparable to a mutual fund in many ways, but it trades like a stock on an exchange.

The fact that ETFs and mutual funds are legally distinct from the companies that manage them is a key feature. They’re organized as “investment firms,” “limited partnerships,” or “trusts,” respectively.

This is significant because, even if the ETF’s parent company goes out of business, the ETF’s assets are wholly distinct, and investors will continue to own the assets held by the fund.

What are ETNs (Exchange-Traded Notes)?

ETNs (exchange-traded notes) are unique. An ETN is a bond issued by a large bank or other financial institution, rather than a pool of securities.

That corporation offers to pay ETN holders the index returns over a set length of time and to refund the investment’s principal at maturity.

However, if something occurs to that company (such as bankruptcy) and it cannot keep its commitment to pay, ETN investors may be left with a worthless or much less valuable investment (just like anyone who had lent the company money).

A significant distinction between ETFs and ETNs is that, unlike ETFs, ETNs are not governed by a board of directors entrusted with protecting investors.

Instead, the issuer makes all decisions regarding the management of an ETN based on the regulations outlined in the ETN’s prospectus and pricing supplements.

In some situations, ETN issuers may engage in proprietary trading or hedging in their own accounts that are detrimental to ETN investors’ interests.

How ETN (Exchange-Traded Notes) Work?

To answer the question ”Is ETN a good investment?” one should understand how an ETN works.

An ETN is a type of exchange-traded note that is often issued by financial institutions and is based on a market index. ETNs are a type of bond.

The ETN will pay the return of the index it monitors when it matures. ETNs, on the other hand, do not pay interest as bonds do.

When the ETN matures, the financial institution deducts fees before paying the investor cash based on the underlying index’s performance.

Investors can buy and sell ETNs on major exchanges, just like stocks, and profit from the difference between the purchase and sale prices, less any fees.

ETNs are not the same as ETFs (Exchange-Traded Funds). ETFs own the equities that make up the index they follow. An ETF that tracks the S&P 500, for example, will own all 500 equities in the S&P.

ETNs do not provide investors ownership of the securities instead, they are paid the index’s return.

As a result, ETNs have a lot in common with debt securities. Investors must have faith in the issuer to deliver the expected return based on the underlying index.

Barclays Bank PLC was the first to launch ETNs. ETNs are often issued by banks and other financial institutions at a price of $50 per share. Part of the market price is determined by the performance of the underlying index.

Characteristics of ETNs

1. Ownership of assets

The underlying assets of the indexes are not owned by an exchange-traded note; rather, it tracks them. The ETN, for example, tracks the gold index but does not invest in gold.

2. Debt that is not secured

The issuer’s creditworthiness and pledge to refund the major investment, as well as any gains or losses, are everything to an investor.

The issuer does not provide any collateral that may be swapped to cover the investor’s losses during issuing the exchange-traded note.

3. The availability of liquidity

ETNs (Exchange-Traded Notes) can be traded through the exchange or directly with the issuing bank on trading days. Early redemption is usually done on a weekly basis and comes with a cost.

4. The expense ratio

Most financial products, including exchange-traded notes (ETNs), have an annual expense ratio. The expense ratio is the fee charged by the fund manager to cover the fund’s management and associated expenditures.

Advantages of ETNs

To answer your question ”is ETN a good investment?” you should know the benefits of ETNs.

Taxes

Investors do not receive dividends or interest rate payments when owning ETNs because they do not hold any portfolio securities.

ETN shares reflect the underlying index’s total return; the value of dividends is included in the index’s return but is not distributed to investors on a regular basis.

ETN investors are not liable to short-term capital gains taxes, unlike many mutual funds and ETFs that distribute dividends on a regular basis. The regular income tax rate is similar to the short-term capital gains rate.

The investor is subject to a long-term capital gains tax when they sell the ETN. Only when the investor sells the ETN does it become taxable. A long-term holder of traditional ETFs would be subject to capital gains tax each year.

The possibility to considerably increase returns by avoiding annual dividend taxes is a key advantage of ETNs.

Currency ETNs, on the other hand, are not subject to this tax treatment thereby answering the question ”is ETN a good investment?”.

Tracking error is decreased

An ETF should, in theory, deliver you the same return as the index it tracks, minus the expense ratio.

However, the gap between an ETF and its index might occasionally be more than the expense ratio. The tracking error is the excess difference between the portfolio’s return and the index’s value.

ETFs that cannot hold all the components of a benchmark index, because there are too many components or because the components are illiquid, may have considerable tracking inaccuracy.

As a result, the ETF’s value and the benchmark index’s value may diverge. The ETN issuer commits to pay the full value of the index, minus the expense ratio, regardless of the index’s performance, effectively eliminating tracking inaccuracy confirming ”is ETN a good investment?”.

ETNs are built on a solid foundation. To approach the benchmark index return, they are typically composed of futures, options, stock swaps, and other securities.

The underlying basis is unimportant to the investor; if the bank’s strategy fails to match the index, the bank is responsible for the remainder of the gains.

Access to the market

ETNs offer investment bank financial engineering technology to the individual investor, allowing them access to markets and intricate strategies that are not possible with traditional retail investing products.

In 2011, Barclays Bank, for example, released ETNs that allowed investors to profit from spikes in stock market volatility as well as another ETN that allowed investors to profit from changes in the shape of the US Treasury yield curve, answering your question ”Is ETN a good investment?”

The risks of ETNs

To answer your question ”is ETN a good investment?” it is important to understand the risks involved in ETNs, some of the risks include:

Credit risk:

ETNs, like unsecured bonds, rely on the creditworthiness of their issuers. Investors in an ETN may receive cents on the dollar or nothing at all if the issuer defaults, and investors should keep in mind that credit risk can alter fast.

Lehman Brothers had three ETNs outstanding at the time of its bankruptcy in September 2008.

While many investors sold these ETNs before Lehman Brothers went bankrupt (only $14.5 million remained in the three ETNs when the firm went bankrupt), those who didn’t get out got pennies on the dollar, answering your question ”Is ETN a good investment?”.

Liquidity risk

ETN trading activity varies substantially, posing a liquidity risk. Bid-ask spreads can be extremely wide for ETNs with relatively little trading activity. One ETN, for example, had an average spread of 11.8 per cent in March 2021.

Issuance risk (also known as fluctuating premiums)

Unlike ETFs, where the supply of outstanding shares fluctuates in response to investor demand, ETNs are produced solely by their issuers, who are effectively issuing fresh debt each time they generate new units. At times, Issuers may occasionally be unable to generate new notes without violating bank regulators’ capital requirements.

Furthermore, banks frequently put internal limits on the amount of risk they are willing to take on through ETNs, and issuers have stopped issuing new notes that have grown too huge or too expensive to hedge.

Investors who pay a premium for ETNs risk losing money if issuance resumes and the premium dissipates, or if the note is called by the issuer and only the indicative value is returned.

For instance, consider one very exotic ETN (TVIX), which was created to follow twice the daily returns of a futures contract index based on the implied volatility of the S&P 500® Index.

The note’s underwriting bank decided to discontinue issuing new shares of the ETN on February 21, 2012. As additional investors tried to acquire the note, supply couldn’t keep up with demand, and the price began to rise far faster than the note’s indicative value.

The ETN’s market price was about 90% higher than its underlying indicative value by March 21. The ETN’s pricing began its dramatic drop back to reality on March 22, 2012, when the underwriting bank declared that it will resume issuing fresh shares.

The ETN’s price dropped about 30% in one day and then dropped another nearly 30% the next, concluding the two-day stretch with a price only 7% higher than the fund’s indicative value.

Closure risk:

An issuer can effectively close an ETN in a number of ways. The note can be called (also known as “accelerated redemption”) by the issuer, who will return the note’s value fewer fees.

However, not all ETNs have accelerated redemption terms in their prospectuses or pricing supplements. Issuers can also delist the note from national markets and suspend fresh issuing, which is a considerably less pleasant option.

When this happens, ETN investors are faced with a difficult decision. They can either retain the note until it matures, which might take up to 40 years, or they can trade the ETN in the over-the-counter (OTC) market, where spreads are much greater than on national exchanges.

Recognizing the potential for investors to be inconvenienced, some issuers have attempted to provide a more note-holder-friendly option by offering to purchase back ETNs directly through tender offers, answering your question ”Is ETN a good investment?”

ETFs or ETNs: Which is Better?

To answer the question ”is ETN a good investment?” one should know which is better, ETN or ETF?

Choosing between an ETF and an ETN in the same product area is mostly determined by your investing time frame.

Given that ETFs have yearly capital gain and income distributions that are taxable events for the holder, but ETNs do not, it appears logical to conclude that ETNs are a superior product for the long-term investor.

While ETNs provide long-term investors with tax benefits, the majority of ETNs provide access to more niche product categories that are not normally advised for long-term investors.

In the United States, there are approximately 140 ETNs actively trading, with the majority of them focused on commodities, currencies, emerging markets, and specialized strategies.

Because of the tax advantages, an investor who wants to diversify a core holding of stocks and bonds and develop exposure to various areas over time might consider ETNs.

Because the tax benefit is eliminated, there is little difference between ETFs and ETNs for an investor hoping to profit from shorter-term developments in commodities or emerging markets.

In similar situations, it’s usually recommended to choose the product with the largest volume and liquidity to get the best transaction pricing.

Is ETN a Good Investment?

Since long-term capital gains are treated more favourably than short-term capital gains and interest, the tax treatment of ETNs should be more favourable than that of ETFs.

While the biggest benefit of an ETN is that the entire gain is treated as a capital gain, this gain is also deferred until the security is sold or matures. That is something that tax-conscious, long-term investors should not take lightly.

FAQs

What are Exchange-Traded Notes (ETNs)?

We know senior unsecured debt obligations that are listed on a national securities exchange as ExchangeTraded Notes (“ETNs”). Investors receive a return based on the performance of an underlying reference asset using ETNs.

An ETN may be linked to equities indices, commodities, currencies, fixed income securities, futures, or any combination of two or more of these reference assets, depending on the applicable listing requirements.

What is the procedure for purchasing ETNs?

ETNs, like other exchange-traded instruments, are purchased on exchanges.

Are ETNs rated individually?

ETNs, on the other hand, rely on the issuer’s rating. A credit rating represents an issuer’s creditworthiness; it is not a recommendation to buy, sell, or retain securities, and it is subject to adjustment or withdrawal by the assigning agency at any time.

Is an Intraday indicative value calculated for ETNs?

No, however, the index has an intraday indicative value1 in most cases. An intraday indicative value may be calculated for ETNs connected to particular asset classes, such as commodities or currencies.

How do I go about selling ETNs?

1. ETNs, like other exchange-traded instruments, can be bought and sold on exchanges.

2. A holder of an ETN may also request that the issuer repurchase it for cash, provided that they meet the applicable size and procedural requirements.

3. An investor can choose to keep the ETN until it matures – typically 15 to 30 years from the date of creation – and receive a payment from the issuer based on the formula described in the prospectus that applies.

What are the similarities and differences between ETNs and ETFs?

1. Buying and selling. On a U.S. exchange, ETNs and ETFs can both be bought and sold. Both goods are typically traded by specialists or market makers.

2. Performance. Both ETNs and ETFs are meant to mirror the performance of a specific index.

Do ETNs trade at a price that is close to their intraday value?

With respect to maturity or an early buyback, the market value of ETNs may fluctuate between the date you purchase them and the applicable valuation date. If you sell the ETNs on the secondary market, you could lose a lot of money.

The market value of ETNs is influenced by a number of factors. The value of the applicable index on any given day will, in general, have a greater impact on the value of the ETNs than any other single element.

Is the principal guaranteed, as it is with other debt securities?

No, ETNs are not principle protected, and there is no guarantee that an investor’s initial investment will be returned. The ETN does give a return that is tied to the performance of a specific index, minus investment expenses.

Because of the investor fees, the index’s value must rise faster than the total amount of investor fees in order to recoup the entire investment. Any return of principal is also subject to the issuer’s credit risk.

Conclusion

”Is ETN a good investment?” We’ve always believed that the credit risk associated with an ETN isn’t worth it. Most investors use exchange-traded vehicles to gain exposure to a certain market segment, not to assess the health of a bond issuer. As a result, ETNs are unlikely to meet their investment objectives.

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