ETNs: What Every Investor Should Know

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etns-what-every-investor-should-know-about-hot-new-debt-securitiesThere was a time not long ago when nobody knew what an ETF was. But as of Nov. 30, assets in the U.S. exchange-traded fund industry totaled approximately $739 billion, after climbing $50.3 billion or 7.3% during the month. This marks an all-time, month-end high, according to State Street Global Advisors.

Now, just when you've gotten accustomed to ETFs, you've probably begun hearing a bit of buzz around their cousins, the ETNs: exchange-traded notes. The first ETN was introduced in 2006, and since then, more than 60 have been issued, with more in the works. These financial securities are growing in popularity, according to Colby Wright, Ph.D., assistant professor of finance at Central Michigan University, and co-author of the paper, Exchange Traded Notes: An Introduction. But Wright says ETNs are often confused with ETFs, and seem to be largely misunderstood by the general investing public -- and even by institutional investors and academicians.

To keep it simple, think of ETNs as senior, unsecured, unsubordinated debt securities. You give your money to the issuer and the issuer promises to return it with interest at some point in the future, typically in 20 to 30 years. They are structured products. Because they are debt securities and not equity securities, you are buying a promise, explains Brenda Wenning, who runs Wenning Investments.

The Basics – and the Risks

ETNs trade on the stock exchange, and you can buy and sell them intraday, just like stocks. They are debt notes with a maturity date. They are liquid, so you don't have to hold them to maturity. Usually, an ETN is designed to track a specific index, and its returns are closely linked to the performance of that index. "Tracking errors are not associated with ETNs, unlike ETFs where it's pretty common to have tracking errors," adds Wenning.

"When buying an ETN, you must give consideration to the credit rating of the issuer," says Wenning. "The issuer should have a good credit rating, otherwise it will impact the price of the ETN." If the issuer/counterparty were to be downgraded, it would impact the price of the ETN. And if the issuer went bankrupt, the ETN could end up worthless. "You do not have an underlying basket of securities to support the price of the ETN, so the issuer plays an important role in how the ETN prices the market," explains Wenning.

Wright agrees that it is important to recognize that ETNs are debt instruments, and they carry default risk -- there are no assets underlying ETN securities, as opposed to most types of ETFs. So depending on the ETN, liquidity risk may be high. Still, they can offer investors simple and relatively inexpensive access to asset classes that may otherwise be difficult, expensive, or risky to invest in, he says.

A unique feature of ETNs is that the interest is usually directly driven by some specific asset class such as oil, gold, or some foreign currency relative to the dollar, says Wright. As an added benefit, they have mostly active secondary markets and can therefore trade like stocks, says Wright. "Put it all together and you get the descriptive title: exchange-traded notes."

"ETNs are a great tool for investing, with the understanding that you have credit exposure to the underlying company," says Michael Goodman, a CPA and certified financial planner with Wealthstream Advisors. "This was huge during the financial meltdown. If you were holding Lehman ETNs, then you could have lost big, so you need to understand this and keep track of your exposure."

Complexities Abound Around Interest, Taxes, Risks and Hedges

Even those investors savvy enough to understand what ETNs are may not be aware that the interest accumulates daily (minus the daily equivalent of the annual expense ratio), which means the total return to the asset driving the interest isn't the only variable determining an investor's total return -- the investor's total return from holding an ETN is also driven by the path that is taken to get to that total return on the asset driving the interest, explains Wright.

Another question is how Uncle Sam figures into the equation. As for taxes, the jury is still out. It is unclear, says Wright, how the IRS views most ETNs. The IRS has stated that currency-based ETNs are to be treated as debt instruments for tax purposes. But non-currency ETNs still represent a gray area, says Wright.

Wright says initially he had a very negative perspective on ETNs, but with each revision of his paper, his attitude changed. "As long as investors understand the default risk, I now think they could play a very useful role in our financial system," he says.

As a matter of diversification, retail investors should be clamoring for simple and affordable ways to invest in asset classes like oil, gold, foreign currencies, and commodities, says Wright. Until recently, investing in these types of assets required the use of futures or other types of lesser-known or highly leveraged financial securities."ETNs can play a really useful role in offering simple and affordable diversification to the average investor," says Wright.

ETN-issuing institutions can hedge a good portion of their liabilities related to these instruments. By issuing two ETNs (one long and one short), related to a given asset class, an issuing firm can create a useful hedge on its obligations (assuming there is demand on the short side equal to the demand on the long side), says Wright. Deutsche Bank has caught this vision, he says. They have several "paired" ETNs which offer both long and short exposure to a single asset class.

"Seems like a win-win for everybody," says Wright. "The issuing institutions can hedge their obligations relatively effectively and earn a respectable fee for the service they provide."

So Wright is now a fan. "Unfortunately the implosion of the Lehman ETNs in 2008 seems to have really spooked the markets (surprise, default risk is a real thing), so I'm just not sure what the future holds for ETNs. I'd love to see them catch on and play the role I think they could."

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