What Is An Exchange Traded Note (ETN)?

Introduction

When we use the term "ETF", we sometimes are actually referring to both Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs).  To be precise, we should use the term "Exchange Traded Products" or "ETPs" to refer to both ETFs and ETNs. But it is easy to sometimes just say "ETF" when referring to ETPs.

As of today, the ETP industry consists of 2,199 ETFs and 124 ETNs. Here is a summary of the ETNs by category:

CategoryETN Count
Alternatives11
Commodities55
Global Equity11
Special Security Types18
US Equity23
US Fixed Income 6
Total124

Mechanically, ETFs and ETNs work the same way. They are both traded on an exchange, and issue and redeem shares through Authorized Participants, as explained in our article ETF mechanics. And philosophically, the concept is the same:   ETFs and ETNs are both funds that attempt to track an index so that you can invest in a variety of financial markets.   

ETNs are structured as senior, unsecured, unsubordinated debts issued by a major bank. These notes have a maturity date and are built to give investor's exposure to various indices - be it in the commodity, equity, or bond space - less fees paid to the bank. The ETNs, however, do not actually hold any securities, instead an issuing bank is just promising to pay to investors the amount reflected by the index's performance (minus fees).

In simple terms, when an investor buys an ETN, the investor is loaning money to the bank. The bank doesn't have to set aside the assets from the ETN into a "special account", or use the assets to purchase securities related to the index the ETN is tracking. Instead, the bank takes the money, and uses the money however the bank sees fit. In return, the bank promises to pay the ETN investor a return based on the return of the index the ETN tracks, less fees paid to the bank.

Behind the scenes, it is unclear what investments, if any, the bank is making related to the ETN, which makes the ETN business a little bit of a mysterious black box. For example, if a bank issues an ETN that tracks an index related to oil futures, is the bank then making investments behind the scenes related to oil futures? If so, is the bank trying to do it in manner that will return more than what they are going to pay to the ETN holder? Or do they merely want to make some kind of investment that will offset what they pay to the ETN holders? In other words, how is the bank making money on the ETN? Is the bank just collecting its fees, which usually run around .85 to 1.00%. ETNs are issued by major investment banks like UBS and Credit Suisse, so they are probably using derivatives trading behind the scenes to cover what they are paying out to the ETN holders.

Here are the companies that sponsor ETNs:

Sponsor CompanyNumber of ETNs
Barclays ETNs43
Etracs ETNs (UBS Bank)21
VelocityShares ETNs19
Bank of Montreal ETNs16
Credit Suisse ETNs7
Elements ETNs7
C-Tracks ETNs (Citi)3
Goldman Sachs ETNs3
Deutsche Bank ETNs3
J.P. Morgan ETNs1
Morgan Stanley ETNs1
Total number of ETNs124

Note that most of these ETN companies are the banks themselves. VelocityShares and Elements are unique in that they market ETNs from multiple banks, including UBS, Deutsche Bank, Citigroup and Credit Suisse.

Benefits to An ETN

1.    ETNs don't have tracking errors.

ETFs own underlying assets - they have to buy and sell assets all day long in an effort to track the index they are trying to follow. They do the best they can, but there is still "tracking error" - i.e. the value of the underlying assets does not go up and down in precisely the same manner as the index they are trying to track.    ETNs, on the other hand, don't own any underlying assets.    So they precisely track the performance of the index, less the fees paid to the bank.

2.    ETNs can track more index types than an ETF.

A bank can theoretically design an ETN around any index, even if it is an index that isn't easily investable. The bank is just promising to pay the ETN holder based on the theoretical performance of the index. The bank doesn't have to actually invest in that index. This flexibility means that they can design an ETN around something that isn't easily investible.

3.    A leveraged ETN can pay leveraged dividends based on the dividends of the underlying index.

Leveraged ETFs can't pay dividends based on the dividends of the underlying index -- it just doesn't work. But a bank can build an ETN around virtually anything, if they can design a way to make money on it. So UBS and Credit Suisse invented a way to build leveraged ETNs that pay leveraged dividends based on the dividends of the underlying index, creating a special class of leveraged high dividend ETNs with extremely high dividend yields. It is unclear how the banks generate enough income to afford to pay out these high dividends, but they must be using leverage and derivatives trading to make it work.

4.    ETNs are suited for investing in MLPs

An investor in a master limited partnership, or MLP, is presented with a more difficult tax situation than normal, because the investor is treated as a limited partner, and has to report on his or her income tax return every year his or her share of the partnership's profit or loss. At the end of the year, investors are issued a tax form K-1, which many investors are not used to. So it has always been a little complicated for an ETF to invest in MLPs. An ETN that is linked to an MLP index avoids this complicated tax situation, because an ETN doesn't invest in an MLP, so the same tax situation doesn't apply. So ETNs related to MLPs are fairly popular - there are currently 20 ETNs that track MLP indexes.

Drawbacks to An ETN

1.   You have to trust the bank that issued the ETN.

Since ETNs are unsecured debt instruments issued by the bank, ETNs face some level of credit risk. This means that if the issuing bank, such as UBS or JP Morgan, were to go bankrupt, investors may not receive their full investment back, if anything at all.  Remember, unlike an ETF which actually owns some type of underlying asset, an ETN doesn't actually own anything.  The bank doesn't set aside any assets into a trust, or otherwise segregate assets related to the ETNs.

In February of 2008, Lehman Brothers had just entered the ETN business by issuing three notes under the Opta name. One was tied to listed private equity companies, and the other two were tied to commodities. Thankfully, none of the funds had gathered any meaningful assets by the time Lehman Brothers went bankrupt just seven months later, in September 2008. However, any investors who did hold shares of these ETNs when Lehman Brothers went bankrupt ended up waiting in bankruptcy court with everyone else who'd loaned money to the firm, hoping to get a few cents on the dollar for their investment. Investors eventually recovered just 9 percent of their ETNs.

A similar fate almost hit investors in Bear Stearns’ ETNs. Fortunately for them, J.P. Morgan honored all Bear Stearns debt obligations when J.P. Morgan acquired Bear Sterns.

2.   The bank may decide to terminate the ETN.

Because ETNs are debt, they have a maturity date - usually about 30 years after the issuing date - when the note's principal is then paid out to investors.    But, the bank generally has the right to terminate the ETN at it's own discretion.    However, keep in mind that the issuer of an ETF can also terminate an ETF at anytime.

3.   The bank may decide to stop issuing new shares of the ETN.

All ETFs and ETNs rely on the sponsor to continually issue new shares when required to keep the net asset value of the fund in line with the trading price of the ETF/ETN. When the trading price of an ETF/ETN's shares starts to get bigger than the ETF/ETN's net asset value per share (the value of the underlying assets), the ETF/ETN's sponsor will issue some more shares, which shrinks the gap between the ETF/ETN's market share and it's NAV per share. This constant issuing of new shares happens all the time, and it's key to how ETF/ETNs operate.

There are times when the sponsoring bank of an ETN will suspend issuing new shares. They have they right to do it when they want to. When that happens, it's hard to predict what will happen to the share price. The ETN becomes a "closed end fund" where the market price of the ETN reflects whatever price investors are willing to pay for it, regardless of the fund's net asset value. This can create an uncertain situation that can make an investor nervous.

There are currently 20 ETNs that have suspended issuing new shares. Click here for the list of ETNs that have suspended issuing new shares.

4.   The bank may exit the ETN business all-together.

It is unclear if the ETN business really is that profitable to the major banks issuing the ETNs. So will they continue to be in the ETN business?

5.   There are a lot of small ETNs with low trading volumes.

There are certain issues associated with both ETFs and ETNs that are small:

a.   The odds are greater that the ETF or ETN will be terminated by the issuer.    In both cases, investors have to be careful about what they do when an issuer announces they are terminating an ETF or ETN.   You won't lose your investment, but it can be a scary process to go through if you haven't been through it before.   

b.   There is a greater chance that the actual mechanism of buying and selling a small ETF or ETN is less efficient.    The spread between bid-offer prices may be larger than normal, meaning that if you don't carefully execute trades using "limit" orders you may unnecessarily cost yourself hundreds of dollars.

ETNs are not necessarily worse than ETFs when it comes to these issues, but a greater percentage of ETNs have a trading volume below 10,000 shares a day:

ETFsETNsTotal
Total2,199124124
Trading volume below 10,000 shares a day74779826
Percentage33.97%63.71%35.56%

6.   ETNs tend to have higher fees

Average fees per our database by category:

ETP TypeCategoryETF CountAverage Expense Ratio
ETF170.0000
ETFAlternatives1240.0063
ETNAlternatives110.0093
ETFAsset Allocation550.0075
ETFCommodities750.0080
ETNCommodities550.0086
ETFGlobal Equity6680.0054
ETNGlobal Equity110.0093
ETFGlobal Fixed Income280.0040
ETNSpecial Security Types180.0086
ETFSpecial Security Types390.0144
ETFUS Equity8300.0046
ETNUS Equity230.0079
ETNUS Fixed Income 60.0070
ETFUS Fixed Income 3630.0031

Average fees in total:

ETP TypeETP CountAverage Expense Ratio
ETF21990.0050
ETN1240.0085

The higher average fee for ETNs probably makes sense given that there are a lot of ETNs linked to indexes that pursue more complex strategies, such as leveraged ETNs, or that are tracking indexes that are difficult to invest in.

7.   The tax treatment of ETNs is unclear

ETNs are unique instruments, and the IRS has never definitively ruled on how they should be treated for U.S. federal tax purposes. Investors should consult their tax advisor about the appropriate tax treatment of an ETN, as the issue is complex. The prospectus of the ETN usually includes a section discussing the potentially different ways that the ETN might be treated for tax purposes. The IRS or the U.S. Congress could change the rules at any time.

If the ETN pays a dividend, the dividend is usually considered to be "ordinary income", somewhat akin to interest income. Dividends from ETNs are not usually considered to be eligible for the special tax rate applicable to “qualified dividends”, notwithstanding that such amounts may be attributable to dividends on the underlying index that would have been “qualified dividends” if the securities in the index had been held directly by an investor.


All data is a live query from our database. The wording was last updated: 06/02/2020.

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