ETNs have seen defaults in the past. Investors in ETNs sold by Lehman Brothers Holdings Inc., for example, only recovered 9 percent of their investment following the bank's failure in 2008. Admittedly, those ETNs had very little in the way of assets. So while overall defaults have been extremely rare, ETNs have been known to abruptly suspend creations and come with nasty hidden fees rarely seen in the ETF structure.
The idea of ETNs gathering assets based on investors looking to avoid government rules and regulations that hinder ETFs is nothing new and is, in fact, already a big part of how they currently make their living and have already amassed $20 billion in assets. In fact, one of the first ETNs ever launched tracked India, which had foreign ownership restrictions at the time and couldn't be tracked by an ETF. The ETN was a workaround for investors desperate for a convenient way to get India exposure.
Nowadays, however, the vast majority of the assets in ETNs are looking to avoid a different kind of governmental reality: taxes.
ETNs are an exception to the general rule of ETF investing, which is that their tax treatment is informed by their holdings. Since ETNs don’t hold anything, generally speaking, they get taxed like a plain old equity ETF. So for areas that have unusual tax treatment—such as commodities futures, VIX futures, and master limited partnerships (MLPs)—ETNs represent an attractive alternative. That is why these three areas alone make up about three-fourths of ETN assets as seen in the chart below.
"ETNs can offer a great tax benefit, both in their favorable tax treatment as well as their ability to avoid distributing K-1 tax forms, which tend to annoy investors," said Corey Hoffstein, co-founder and CIO of Newfound Research.
As such, some investors simply choose to stomach the ETN's structural and credit risks in order to avoid the tax treatment found in certain ETFs. Many other investors are happy assuming the different tax treatments in exchange for avoiding any ETN- related risks.
But if the new SEC rules are put forth as proposed, investors' risk-reward calculations could well be upended.