How Exchange-Traded Notes Work: Unlocking The Potential

Image Source: The Wall Street Journal

Exchange-traded notes (ETNs) represent a form of loan instrument provided by financial entities like banks, featuring a predetermined maturity ranging typically between 10 to 30 years. These instruments are tradable based on market demand and supply dynamics. Unlike traditional debt instruments, they don't yield interest for the lender. Instead, investors' gains or losses are contingent upon the performance of an asset class or index they are linked to. Investors have the choice to trade these instruments before maturity or hold onto them until maturity to realize returns.

Operation of Exchange-Traded Notes (ETNs)

These instruments are issued by underwriting banks and their returns are tied to the performance of a specific stock index. Essentially, they function akin to bonds, paying out the returns of the tracked index upon maturity, albeit without the interest payments characteristic of traditional bonds. Upon maturity, the issuing financial institution reimburses investors with an amount reflecting the performance of the underlying index. Traded on major markets like futures, investors can capitalize on the price differentials between buying and selling rates, net of any associated fees. ETNs don't grant ownership of the underlying assets but rather offer returns based on the index's performance, akin to debt instruments. Therefore, investors must trust in the issuer's ability to generate returns tied to the underlying index. So, these differentiate ETFs and ETNs.

Characteristics of ETNs

Asset Ownership

Exchange-traded notes don't possess the underlying assets of the indices they track; rather, they mirror them. For instance, an ETN may track the gold index without holding any physical gold.

Unsecured Debt

Investors depend entirely on the issuer's creditworthiness and commitment to repay the principal investment along with any profits or losses incurred. The issuer doesn't offer collateral during the issuance of the instrument to cover potential investor losses. So, there is no fixed income.

Liquidity Offered

These instruments can be traded on trading days either through the exchange or directly with the issuing bank. Early redemption typically occurs on a weekly basis and may entail a redemption fee.

Expense Ratio

Similar to most financial instruments, these often entail an annual expense ratio. This ratio represents the fee charged by the fund manager to cover fund management and other expenses.

Benefits of ETNs

Tax Savings

Unlike mutual funds, investors don't receive monthly dividends or interest, and there are no capital gains distributions throughout the year with these instruments. Instead, any gain or loss is deferred until it is sold or matures, treated as a long-term capital gain with a more favorable tax rate of 20% compared to short-term capital gains.

Access to Diverse Markets

Some markets, such as currency, commodities futures, and international markets, pose high commission prices and minimum investment requirements, making them inaccessible to small investors. These instruments don't have such limitations, offering accessibility even to small institutional investors.

Accurate Performance Tracking

As ETNs don't possess underlying assets, rebalancing isn't necessary, unlike with exchange-traded funds. These instruments replicate the value of the index or asset class they track.

Liquidity

These instruments can be bought or sold during normal trading hours on securities exchanges or sold back to the issuing bank on a weekly basis. Investors can monitor the performance of these debt instruments akin to stock investments.

Limitations of ETNs

Limited Liquidity

While exchange-traded funds (ETFs) can be traded throughout the day, allowing agile traders to capitalize on price fluctuations, these instruments typically exhibit lower liquidity compared to stocks. Investors looking to dispose of large blocks of units may only have the opportunity to do so once per week, exposing them to risks associated with prolonged holding periods.

Credit Risk

In addition to market risk, which exposes investors to the possibility of underperforming underlying assets, these instruments also entail credit risk. If the issuing institution defaults, investors may lose both the principal investment and any returns. Furthermore, negative news concerning the issuer can impact the price of the ETN.

Limited Investment Options

The demand for these instruments is relatively lower compared to other investment products, resulting in fewer available options, with costs varying widely. While issuing entities strive to maintain consistent valuations, the methods employed may introduce fluctuations.

Tax Treatment of ETNs

Generally, the difference between the purchase and selling prices of these instruments is treated as capital gains or losses for income tax purposes. Investors can defer recognizing gains until the ETN is sold or matures. However, consulting a tax professional is advisable to understand any specific tax efficiency and implications pertinent to individual situations.

Real-World Example of an ETN

The JPMorgan Alerian MLP Index ETN (AMJ) serves as an example of an energy infrastructure ETN, tracking energy sector companies operating as master limited partnerships (MLPs). With assets exceeding $2.9 billion and an expense ratio of 0.85%, AMJ has experienced share price fluctuations ranging from $7 to $26 per share since 2019. It's crucial for investors to acknowledge the inherent risks associated with these instruments, including credit risk and the potential for significant share price declines, as demonstrated by AMJ.

Conclusion

Exchange-traded notes offer investors a unique opportunity to gain exposure to various asset classes or indices without direct ownership of the underlying assets. These financial instruments, issued by financial entities like banks, track the performance of specific indices or asset classes and can be traded on major markets. Unlike traditional debt instruments, ETNs don't yield interest for the lender; instead, investors' returns are based on the performance of the tracked index. These instruments provide benefits such as tax savings, access to diverse markets, accurate performance tracking, and liquidity. However, they also come with limitations, including limited liquidity, credit risk, and fewer investment options.

Understanding the workings of these instruments empowers investors to make informed decisions about incorporating them into their portfolios. As with any investment, it's crucial for investors to conduct thorough research, consider their risk tolerance, and consult with financial professionals before investing in ETNs. With proper diligence, they can serve as valuable tools for diversification and potentially enhancing investment returns.