Exchange-traded note

An ETN offers a tax-efficient way to invest. It is treated as a prepaid contract (such as a forward contract) for tax purposes. The buyer of a prepaid contract pays an initial amount in order to receive a future payment based on the value of an index or other underlying benchmark at a specified future time.

Very often index mutual funds and ETFs are required to make yearly income and capital gains distributions to its fund holders that are taxable. When a fund is forced to sell stock to rebalance or otherwise change its composition, the fund holders have to pay any resulting capital gains tax.

With ETNs, in contrast, there is no interest payment or dividend distribution, which means there is no annual tax. Capital gain (or loss) is realized when an investor sells the ETN or it matures. Long-term capital gains are treated more favorably than short-term capital gains and interest in the US (> 1 year holdings are taxed at a capital gains rate of 20%). There is no way to avoid paying capital gains tax, but there can be great advantage in wealth building by delaying it.

Recent tax rulings have suggested that ETNs may be qualified tax shelters for the purpose of changing current interest income into deferred capital gains income.[2]

ETNs give investors a broad-based index without any tracking error to the index, doing away with the discrepancies that exist between the returns of many ETFs and their underlying indexes. One reason of the tracking error observed in ETFs might be attributed to the diversification issues that stem from the inability of a fund to replicate an index due to an upper limit on the maximum asset allocation to a single stock. But for ETN, this constraint does not exist, because though ETN is also tracking the index, the return is not based on the underlying securities. The ETN issuer guarantees the holder a return that is an exact replica of the underlying index, minus expense fees. The bank also agrees to pay large shareholders the exact value of the note on a weekly basis through redemption, which helps the ETNs track very closely to the underlying index return.

ETNs are a significant innovation to improve liquidity of structured products. Unlike other buy-and-hold structured products, ETNs can be bought and sold during normal trading hours on the securities exchange. For institutional size redemption, investors may offer their ETN for repurchase by the issuer on a weekly basis. Investors can easily track the performance of their ETN. In this sense, ETNs are structured to resemble ETFs. But ETNs are different from ETFs, as they consist of a debt instrument with cash flows derived from the performance of an underlying asset – a structured product.

ETNs have provided access to hard-to-reach exposures, such as commodity futures and the Indian stock market. Certain asset classes and strategies are not easily accessible to individual investors. For example, the “momentum investing” strategy, which is used in SPECTRUM Large Cap U.S. Sector Momentum Index, is to take advantage of the varied performances of the 10 sub-indexes of the S&P 500 Total Return IndexSM (SPTR) relative to each other and to the SPTR. The weights of the 10 sub-indexes are computed each day based on performance and correlation. This makes SPECTRUM Large Cap U.S. Sector Momentum Index difficult to track through ETF. On the contrary, ETN provides opportunities to gain exposure to these types of investment strategies in a cost-efficient way.

Some of the ETNs offer leverage instead of directly tracking a benchmark's performance. For instance, the DGP ETN offered by Deutsche Bank moves in the same direction as gold, but involves double leverage - it replicates twice the returns of holding gold. If gold gains 1%, the note gains 2%. Consequently, if gold goes down by 1%, the note loses 2%.[3] Such characteristics make ETNs suitable for experienced investors willing to take on additional risk in hope of a higher return.

ETNs, as debt instruments, are subject to risk of default by the issuing bank as counter party. This is the major design difference between ETFs and ETNs: ETFs are only subject to market risk whereas ETNs are subject to both market risk and the risk of default by the issuing bank. Even though the possibility of default turning into a reality is relatively low, it ought to be measured and accounted for.[4] ETN investors will require a credit risk metric that facilitates answer to questions regarding the magnitude of the risk and its variation with time. With new players foraying into the ETN space, how will the risk vary by issuer? Who will take up the risk evaluation process? If and when the ETN sector grows, in order to participate, retail and institutional investors will need a source for ETN key data which is easy to assimilate.

Given the relative newness of ETNs, not all enjoy high liquidity. The effectiveness of ETNs at tracking indices is contingent on their ability to garner enough support in the market.

Another flipside of ETNs relates to their redemption feature. While ETNs can be sold daily on the secondary markets or held until maturity, institutional investors who wish to redeem blocks of 50,000 units or more directly with the issuer can only do so once a week. In contrast, other structured products, ETFs for instance, can be redeemed anytime during a trading day.

The ETN issuers are using tax efficiency as their trump card. As things stand, there is significant tax saving to be gained from investing in ETNs. In reality, however, the Internal Revenue Service has yet to decide on the proposed tax treatment. So, the tax benefit status is still arguable.

ETNs have their worth decided by two factors:

• Performance of the index they are set to track
• Credit ratings of the issuer

Suppose the issuing bank has been impacted negatively, if only marginally, by a crisis like the 2008 subprime mortgage crisis and the ratings agencies depreciate the overall credit rating of the issuer to reflect the event. In this hypothetical case, even though the index it is tracking is showing growth, a decline in rating of an ETN issuing financial institution could negatively impact the worth of an ETN.[5]

The GSCI has lost nearly 20% of its value since January 2006, despite soaring commodity prices, all thanks to contango. This is one instance where ETN tracked commodity indices like GSCI have ended up doing exactly the opposite of what they had set out to do.

Contango is a scenario where the cost of the next-month futures contract is costlier than the current month contract. In this event, the issuing bank books a loss each time a current month contract is sold and the next month contract is bought. Contango has hit hard the energy futures over the past few years and markedly brought down the returns from energy markets. Indices are taking varied steps to hedge against the condition. Their results remain to be seen.

The UBS Bloomberg Constant Maturity Commodity Index (CMCI) addresses the issues of contango and backwardation by introducing the concept of constant maturity, which provides diversification across futures contract maturity dates. This is intended to smooth out the volatility often associated with commodity investments.[6]