What is an ETN

An exchange-traded note, also known simply as an ETN, is the sister-investment of the exchange-traded fund. Whereas exchange-traded funds hold anything from stocks to bonds, to commodities, or a combination of different types of investment products, exchange-traded notes hold only notes. In this case, we’re not talking about Treasury notes. Instead, we’re talking about promises.

In layman’s terms, a note is a contract between two parties that triggers upon a certain event. In many ways, a note is simply a bet.

As an example, we’ll use a made up oil exchange-traded note. Unlike ETFs, which may hold oil producing stocks, oil futures, or oil itself, the exchange-traded note version of the oil fund holds only a promise by one or many companies to make good on the terms of the product when the price of oil rises or falls.

The company that issues the ETN often hedges the bet itself. For each dollar invested into a particular ETN, the issuer agrees to take the counterparty position. Thus, if investors pile $1 billion into an exchange-traded note, and the underlying product rises 10%, the counterparty to the note would have to pay up to the tune of $100 million. However, if the underlying product (oil, in our example) were to decline by 10%, the issuing company would make $100 million.

Remember, no one actually owns any oil. Instead, investors own a bet on the price of oil.

Why investors like ETNs
Exchange-traded notes work excellently to create investment products that simply might not exist in their physical form. Oil, for example, is difficult to store as it is heavy, and bulky. Also, any massive store of oil would be expensive to insure, as it would run the risk of a highly destructive fire. Oil futures aren’t exactly a solution, either, as contangos in price from one month to the next slowly devalue investors’ position in the oil market, even if the price of oil rises over time.

Exchange-traded notes also aid investors in giving them the option to buy or sell a specific position in a highly tax-advantaged structure. Gold, being one of the worst investments for tax purposes, is an excellent investment through an ETN. Where gold held for more than one year in its physical form is taxed as a collectable—at the buyers’ income tax rate—gold ETN gains are taxed as capital gains, which cap at 15% compared to 35% for income.

Why investors fear ETNs
As you can imagine, there are some risks in buying and selling ETNs as an investment. For one, the price of the ETN is not backed by anything tangible—an oil ETN with $500 million in assets will hold not a single drop of oil, but instead a promise by one or many people to make good on the changes in price. Well, what happens when the price rises too high or too low, and the issuing party runs out of money? Investors get nothing.

You see, investors are exposed to what is known as “counterparty risk.” Counterparty risk is essentially a finance term for risks that result from taking a bet with another person or entity. If the fund issuer or backers go belly-up, so do investors.

While no exchange-traded funds have been directly affected by counterparty risk, many financial markets have in the past. The 2008 financial crisis was almost wholly dependent on counterparty risk, with the failure to pay by one or many banks resulting in a chain-reaction all around the globe. There is a real risk with exchange-traded notes that won’t be found anywhere else, and should be accounted for in any potential ETN investment.

Comments are closed.