2. The tax-advantages of ETNs are uncertain.
Although ETNs are touted for their tax efficiency over mutual funds and ETFs, how they are taxed is far more complicated and uncertain. For example, commodity-linked ETNs are taxed at the same capital gains rate as the commodity futures they use when the futures contracts they own are rolled. On the other hand, commodity ETNs that invest in physically backed precious metals would have a maximum long-term capital gains tax rate of 20% compared to 28% in a gold-back ETF. And ETNs that track currencies and equities are taxed at varying rates.
More importantly, the IRS has yet to give its official opinion about the taxation of stock and bond ETNs. Currently, these types of ETNs have no annual tax because there is no interest or dividend distributions made. A capital gain (or loss) is realized when shareholders sell their notes or hold them to maturity.
Most prospectuses acknowledge the uncertainty surrounding the tax treatment of ETNs, but how much damage would a negative tax ruling by the IRS have on ETN shareholders?
3. The history of ETNs as long-term investment products isn’t very promising.
The failure of the Lehman Opta ETNs raises serious doubts about the viability of ETNs should backers encounter financial problems. While many ETNs have a long-term maturity date that can be anywhere from 20 to 30 years, the viability of an ETN sponsor can quickly change for the worse.
While well-known ETN sponsors such as Barclays, JPMorgan Chase and UBS don’t appear to be in a crisis like Deutsche Bank, advisors should error on the side of caution. Moreover, many of the specialized asset classes that ETNs exclusively covered in the past are now offered in an ETF wrapper.
Before buying ETNs, advisors should do their due diligence to check for an ETF alternative that offers market exposure to the same asset class. The latter choice may have slightly higher tax consequences and tracking error, but these disadvantages may be offset by the significant credit and taxation risks of ETNs.
To put it another way, investors should approach ETNs with caution.
Ron DeLegge is founder and chief portfolio strategist at ETFguide.