3 Reasons To Own An ETN

December 14, 2016

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:

Taxes

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.

 

Access

If an ETN allows you to access a market you otherwise couldn’t access on your own, then owning an ETN makes sense. Many ETNs focus on commodities and currencies, and many investors don’t want to open a futures trading account to access these markets. They might already have, however, an equity brokerage account, so they can buy a currency position or a commodity position directly via an ETN.

For many, that’s a better way to access a market than having to deal with opening another account, margins, approvals, etc.

Concentration

ETNs are not ’40 Act funds. Because of that, they can go around what you might call “structural limits” of ’40 Act products. One of those limits is concentration. The regulation imposes restrictions on fund concentration in an effort to ensure a basic level of diversification in these funds—think of it as an investor protection measure.

As an investor, if you want a really concentrated portfolio, ETNs might be the way to go because they can be highly concentrated on single positions.

“Taking on counterparty risk is not something people would do lightly, and in the equity space, you don’t see a lot of ETNs, because there’s not much an ETN can do for you there that other structures can’t,” said Elisabeth Kashner, director of ETF research at FactSet. “They are popular in the MLP space where there are complicated tax rules. Outside of that, the biggest place is in commodities to avoid K-1 and mark-to-market.”

“In the end, everyone is facing a trade-off,” she added. “Most investors want to find the sweet spot between the risk and the reward. ETNs might offer benefits, but they also have risks.”

Contact Cinthia Murphy at [email protected]

 

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