In the $2.5 trillion world of U.S. listed exchange-traded products, ETFs dominate product launches as well as asset gathering. The exchange-traded note structure gets far more limited attention, and it has yet to catch on.
ETNs are debt notes issued by a bank. When you buy an ETN, that bank essentially promises to pay you a certain pattern of return, and unlike ETFs, ETNs come with counterparty risk—the risk the issuing bank might falter on its obligation to you.
There are a few blockbuster successes among ETNs, such as the $3.6 billion J.P. Morgan Alerian MLP Index ETN (AMJ) and the $1.4 billion iPath S&P 500 VIX Short-Term Futures ETN (VXX), to name a few. In fact, at least 10 ETNs today each have $500 million or more in assets under management.
107 ETNs Face Closure Risk
Yet out of the 188 notes on the market, a whopping 107 are facing high closure risk. That risk takes into account not only assets under management, but also how close an ETN is to its liquidation threshold. Some ETNs have language in their prospectus stipulating limits, saying things like “if NAV [net asset value] gets below $X,” or “if NAV drops 50%” or something similar, that ETN will be closed.
Beyond closure risk, there’s also the issue of liquidity. A lot of these strategies struggle with thin, wonky trading at times, and ultimately face high trading costs, which further discourages many investors from buying in. It’s a bit of a vicious circle. And there's the issue of counterparty risk.
Ultimately, there aren’t any ETNs on the market today that offer a strategy you couldn’t really find in an ETF wrapper. So why would anyone own an ETN?
There are three main reasons someone might:
With an ETN, an investor might get a better deal on taxes, particularly in commodities. If you have a futures-based position, it’s marked-to-market, and you are going to get a K-1—something many investors don’t want. ETNs don’t distribute K-1s.
It’s crucial to remember that ETNs are basically a “prepaid forward contract,” to quote The Tax Adviser, whereas most ETFs are “structured as regulated investment companies.”
As such, investors are only paying taxes on gains/losses at the time of redemption or sale of that contract. “Accordingly, the ETN allows the taxpayer to defer the recognition of income until the disposition of the contract and eliminates the ordinary interest income factor associated with normal debt and notional principal contracts.”
ETFs, meanwhile, have annual distributions and can have capital gains annually.