What it means
An ETN looks like a share or an exchange-traded fund (ETF) on your trading screen, but it works differently underneath. A bank issues the note and agrees to pay the holder an amount tied to an index, such as a commodity index or a volatility index, minus fees.
Since it is a promise to pay, the note is a form of unsecured debt (a loan with no collateral behind it). The big difference from an ETF is credit risk.
An ETF holds a basket of real assets that belong to the investors, whereas an ETN holder is a creditor of the issuing bank. If the bank gets into serious trouble, the investor could lose some or all of the money even when the index itself performed well.
Investors use ETNs to reach markets that are hard to access directly, such as certain commodity or currency strategies. An ETN can also avoid tracking error (the gap between a fund and its index) because the issuer simply promises the index return less a fee.
In some countries the tax treatment can also differ from that of funds, so it is worth taking advice. ETNs usually have a maturity date and an annual fee, which is taken out of the return over time.
Many allow the holder to sell on the exchange at any time, but the price depends on supply and demand and on the issuer's credit standing. Some notes also allow early redemption directly with the issuer, often in large blocks.
Issuers have the right to close certain notes early, which can force investors to sell at an unwelcome moment. The bank's credit rating therefore needs to be part of any assessment.
A strong index return gives no comfort if the issuer's rating is weak. For a corporate treasurer or a private investor, the key point is to read the prospectus and ask who is on the other side of the promise.
If the product is only attractive because of the index, a fund might be a safer way to get the same exposure.
In practice
Real-world examples.
Example
A retail investor in London buys an ETN linked to a commodity index because buying physical commodities is impractical. She checks the issuing bank's credit rating before investing, since the note is only as strong as the bank behind it.
Example
A corporate treasurer in Toronto looks at an ETN to hedge exposure to a basket of metals. He decides against it because the company's investment policy does not allow unsecured exposure to a single bank.
Example
A wealth adviser in Sydney explains to a client that two products with the same index carry different risks. The ETF holds the assets, while the ETN is a promise from a bank, so the adviser recommends limiting the ETN to a small share of the portfolio.
Formula
Calculation
Approximate value of an ETN at maturity = initial investment x (final index level / initial index level) - fees
Worked example: an investor puts $10,000 into an ETN that tracks an index. The index starts at 1,000 and finishes the year at 1,200. The issuer charges an annual fee of 0.75% of the final value.
Step 1: Index growth = 1,200 / 1,000 = 1.20, so the gross value is $10,000 x 1.20 = $12,000.
Step 2: Fee = 0.75% x $12,000 = $90.
Step 3: Value at maturity = $12,000 - $90 = $11,910.
The investor earns $1,910, or 19.1%, provided the issuer pays as promised. If the issuer fails, the investor ranks as an unsecured creditor and could receive far less.Case study
Seen in the real world.
Lakeshore Capital is a fictional investment boutique that offered clients a volatility-linked product through an ETN. The index performed as the clients hoped, rising 30% over a quarter.
During the same quarter, the issuing bank faced a sharp fall in its credit rating after unexpected losses elsewhere in its business. The ETN's trading price rose by less than the index, because buyers demanded a discount for the extra risk of the issuer failing to pay.
In this illustrative case, clients learned that an ETN carries two risks, the index and the bank. Lakeshore afterwards added a rule to its review process: no more than 5% of any client portfolio in notes from one issuer.
Watch out
Common mistakes.
- Treating an ETN as if it were an ETF, when the ETN is unsecured debt and the ETF holds real assets.
- Looking only at index performance and ignoring the credit rating of the issuing bank.
- Forgetting that annual fees and possible early closure by the issuer can reduce the final return.
Questions
People also ask.
What happens to an ETN if the issuer goes bust?
The holder becomes an unsecured creditor and may recover only part of the value, even if the index has risen.
Can you sell an ETN before it matures?
Usually yes, on the exchange, but the price depends on market demand and on how the market views the issuer's credit.
Does an ETN pay interest like a bond?
Some notes pay a coupon but many pay nothing until maturity, so check the terms in the prospectus.
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