Exchange Traded Notes - An Alternative To ETFs

By Investopedia Staff AAA

ETN - short for exchange traded note - is the investment industry's latest acronym. ETNs are similar to exchange traded funds (ETFs), but differ in structure. ETNs are issued by Barclays Bank - the ETF industry's largest provider. Three ETNs are currently available: two representing the primary commodities indexes; Goldman Sachs Commodities Index (GSCI) and the Dow Jones-AIG Commodity Index, and the other, oil.

SEE: Commodities: The Portfolio Hedge.

In this article, we'll explain this innovative approach to index investing and compare it to its cousin, the ETF. (For more insight, see Introduction to Exchange Traded Funds and An Inside Look At ETF Construction.)

How Is an ETN Different Than an ETF?
ETNs are structured products that are issued as senior debt notes by Barclays, while ETFs represent a stake in an underlying commodity. Barclays is a 300-year-old bank with $1.5 trillion in assets and an 'AA' credit rating from Standard & Poor's.

This provides ETNs with a fairly dependable backing, but even with this kind of credibility, ETNs are not free of credit risk - after all, Barclays Bank will never be as safe as a central bank, such as the Bank of England. In the 1990s, for example, Barings Bank (which was as reputable as Barclays, at the time) collapsed as a result of the large losses incurred by a speculative trader employed at the bank.

Tax Treatment
ETNs track their underlying indexes minus an annual expense of 75 basis points per year. Unlike ETFs, there are no tracking errors with ETNs. Based on Barclays' recommendation, investors should treat ETNs as prepaid contracts. This means that any difference between the sale and purchase will be classified as capital gains. There are no other distributions with ETNs. In comparison, the return from commodity-based ETFs will come from the interest on treasury bills, short-term capital gains realized on the rolling of futures contracts, and long-term capital gains.

{C}

Since long-term capital gains are treated more favorably than short-term capital gains and interest, the tax treatment of ETNs should be more favorable than that of ETFs. However, as of November 2006, the IRS had not made a definitive ruling on their tax treatment. For international investors, the differences are compounded as treatment for these capital gains and will be treated differently in their home countries. (For related reading, see Capital Gains Tax 101.)

Risk
Outside of the tax treatment, the difference between ETNs and ETFs comes down to credit risk vs. tracking risk. ETNs possess credit risk, so if Barclays goes bankrupt, the investor may not receive the return he or she was promised. An ETF, on the other hand, has virtually no credit risk, but there is tracking risk involved with holding an ETF. In other words, there is a possibility that the ETF's returns will differ from its underlying index.

The following chart represents a comparison of the GSCI's ETF and ETN.

Features ETN ETF
Issuer Barclay\'s Bank Barclay\'s Global Investor
Liquidity Daily, On Exchange Daily, On Exchange
Registration Securities Act of 1933 Investment Company Act of 1940
Recourse Issuer Credit Portfolio of Securities
Principal Risk Market and Issuer Risk Market Risk
Institutional Size Redemption Weekly, To the Issuer Daily Via Custodian
Short Sales Yes, On an Uptick or Downtick Yes, On an Uptick or Downtick
Tracking Error No Yes
Expense Ratio 75 bps 75 bps
Source: iShares

And the Winner Is...
Now that you have a better understanding of the differences between ETN and ETF, which one should prevail? To some degree that will be determined by your tax bracket and your investment time horizon. While the biggest benefit of an ETN is that the entire gain is treated as a capital gain, this gain is also deferred until the security is either sold or matures - something that should not be taken lightly by tax-conscious, long-term investors. With an ETF, capital gains and losses are realized as each futures contract is rolled into another one.

A ruling by the IRS would help remove the tax uncertainty of ETNs. As it stands now, the view that ETNs are classified as prepaid contracts is one that has been made by Barclays and not as an official ruling by the IRS. However, giving taxes higher priority over the quality of an investment can be perilous - the tax code and tax rates are always subject to change.

The absence of tracking risk is also of some value for ETN investors, but it should not be overrated because this has not been a big problem with ETFs. Furthermore, the question of liquidity for ETNs has not yet been answered.

The Bottom Line
The big difference between ETNs and ETFs is credit risk and tax treatment. While much can be made about the counterparty risk of ETNs, is it really any different from the counterparty risk that exists in the structured product and derivatives markets today?

At this point, Barclays has only introduced three ETNs, but their unique structure means that they could be applied to any tradable index. This opens the door for the potential development of many more ETNs in the future, as asset classes like timber, foreign currency bonds, foreign commercial real estate and equity volatility in the U.S still lack an index security.

While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions.

Related Articles
  1. Although several may try to describe the U.S. stock market as “fairly priced,” value-oriented investors recognize the lofty premium for what it is.
    Stock Analysis

    Where Are Foreing Markets Compared To ...

  2. Africa's economic growth and growing stability has gotten the attention of adventurous investors. What kind of ETF or mutual fund options are available?
    Mutual Funds & ETFs

    Destination Africa: These Funds Offer ...

  3. The iShares FTSE China 25 Index Fund etf has become popular with investors seeking China exposure. Here's why.
    Stock Analysis

    This ETF Offers Easy Access To China's ...

  4. With its huge population and booming economy, China is tops for many emerging markets investors. Here's a leveraged ETF for those who want to double down.
    Stock Analysis

    This Leveraged ETF Is For China Bulls

  5. These ETFs are an excellent place to start for any investor interested in betting on Latin America.
    Mutual Funds & ETFs

    Interested In Latin America? Eye These ...

Trading Center