Some investors use the terms “exchange-traded note” and “exchange-traded fund” interchangeably, but the two investment structures are vastly different.
Designed to help investors access harder-to-reach markets such as commodities, master limited partnerships and currencies, ETNs offer a favorable tax treatment and little tracking error, which are two of their biggest selling points. But ETNs are also very complex and can be easily misunderstood. While some industry sources say ETNs offer efficient ways to access alternative asset classes for satellite holdings, others frown on their use.
Pros And Cons
The key difference between ETNs and ETFs is that the former are unsecured debt instruments and ETFs are equity instruments. ETNs can be held to maturity or sold. And whereas ETFs are backed by their underlying stocks, the critical factor in ETNs is the creditworthiness of their underwriters, which are usually banks. That exposes holders to credit risk—and not just hypothetically. Think back to the demise of Lehman Brothers during the financial crisis, when its line of three Opta ETNs—two were linked to commodity indexes and the other to a private equity index—stopped trading and noteholders got back roughly 9% of their notes’ intrinsic value.
ETNs are promissory notes issued by banks; they hold no assets and are designed to pay the return stream of whatever their notes are based on, less fees. With no portfolio manager to manage assets, there’s no churn and very little tracking error, which improves their tax efficiency. Contrast that with the high turnover in ETF portfolios. This can increase the funds’ tracking error and spur tax problems when there is a lot of trading, says Ian Merrill, managing director at Barclays, which offers an extensive suite of iPath ETNs.
ETNs are generally taxed as short-term or long-term capital gains when they mature or are sold, and ETN investors receive a 1099 tax form. Some notes offer targeted exposure to commodities, and their structure is considered more tax-efficient for commodities than ETF’s.
Commodity pool ETFs, for instance, such as the popular United States Oil Fund (USO), issue K-1 tax forms annually to shareholders—even to those who aren’t selling fund positions. That’s because commodity pools are considered limited partnerships, and at year’s end their assets are marked to market—meaning any gains passed on to investors are taxed, even if the shares aren’t sold. Because these types of funds track futures, they’re taxed at a 60% long-term/40% short-term rate, which, when blended, is just under 30%. Investors (and their accountants) generally don’t like K-1s because they’re often issued late in the tax season, requiring taxpayers to refile.
Merrill says Barclays created and launched the first ETNs in 2006 in response to demand from registered investment advisors who wanted easier access to commodities. At the time, investing in that asset class required you to buy a commodities-pool ETF or buy futures contracts and then receive a K-1—or else buy the physical goods themselves. As debt instruments, ETNs don’t own anything, so there are no K-1s to hassle with. And since they are still exchange-traded, investors can buy and sell them without waiting for the notes to mature.
ETNs have been a niche product from the get-go, and their current asset totals reflect that secondary status to ETFs. Specifically, ETNs represent about $25 billion in total assets in the U.S., whereas the entire U.S.-listed exchange-traded product market is roughly $3.5 trillion, (the vast majority being ETF assets). Aside from Barclays, other top ETN issuers include Credit Suisse and UBS.
Although ETNs have been around for 12 years, they remain murky to a lot of investors. For example, Merrill says, many people don’t understand that the notes track an index rather than provide direct exposure to a commodity.