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Understanding Exchange-Traded Notes

Exchange-traded notes, or ETNs, are a relatively new type of investment that share some characteristics with both bonds and exchange-traded funds (ETFs).

ETNs as Unsecured Obligations

ETNs are debt securities. This means the issuer is essentially borrowing money from you, the investor, for a predetermined amount of time. Much like bonds, ETNs have a maturity date. When you buy an ETN, the issuer is promising to pay you an amount commensurate with the performance of the underlying benchmark during the time you held the note, minus fees, at maturity. However, ETNs do not typically pay interest or have any protection of principal.

ETN Benchmarks

So, what is the underlying benchmark? ETNs can track the performance of anything from indexes to commodity futures to foreign currencies. In this way, they resemble ETFs. However, while ETFs invest in securities to allow them to track the underlying benchmark, ETNs do not actually own what they are tracking.

ETN Value

The value of ETNs is determined by several factors. The two primary elements impacting ETN value are the performance of the underlying benchmark and the credit rating of the issuer. For example, if an ETN is tracking an index, and the index is staying level but the issuing bank's creditworthiness comes into question, the ETN would likely lose value. Other factors impacting value can include the ETN's liquidity in the marketplace and the perceived direction of the underlying benchmark. ETNs do not have a net asset value.

ETN Trading

Individual investors can trade ETNs on the secondary market (a stock exchange) through a broker like Scottrade. This is similar to the way other common investments like stocks, bonds and ETFs are traded. Also like these investments, ETNs can be traded throughout the market day as market demand allows.

ETN Creation & Redemption

The ETN creation process is much simpler than ETF creation because the issuer is not purchasing any underlying securities. The redemption process is also simplified because shares can be redeemed by anyone with sufficient holdings, and no Authorized Participants are required. ETNs can be redeemed from the issuer before the maturity date in large blocks of notes, and the prospectus will detail the number of notes or dollar amount that is required for early redemption. Typically, the number is high, in the neighborhood of 50,000 notes, so shares are only redeemed or repurchased by institutional investors. This can be done on a weekly basis.

ETNs at Maturity

At maturity, the issuer will pay the investor a sum of money based on the performance of the underlying benchmark, the investor fees, and the calculation procedure detailed in the prospectus.

To illustrate how ETN payouts are calculated, let's use one of the original ETNs as an example. The Barclay's S&P GSCI Total Return Index ETN was one of two ETNs released by Barclay's in 2006 when the bank first introduced the ETN. This note tracks the S&P 500.

If you purchased this security, you could calculate the payment at maturity according to the following graphic (based on information found in the note's prospectus):

View Graphic

Potential ETN Risks

Some of the risks unique to ETNs include:

  • Unsecured - ETNs are unsecured debt instruments, which means that investors have the potential to lose all of their investment if the issuer loses the ability to repay the debt.
  • Liquidity - ETNs are a relatively new type of investment, so there may not be sufficient buyers or sellers in the secondary market when an investor wants to enter or exit an ETN position.
  • Counter-Party Risk - In addition to the market risk experienced by most investments, ETNs also carry a credit risk because their value is so closely tied to the credit rating of the issuer.

Potential ETN Benefits

Investors may find that the benefits of ETNs include:

  • Market Exposure - ETNs provide a vehicle for exposure to asset classes that may otherwise be difficult for an individual investor to invest in.
  • Tax efficiency - With ETNs, there are no interest payments or dividends, so there is no regular income on which an investor may be required to pay taxes. Investors may need to pay capital gains taxes when the ETN is sold or matures, however.
  • No Tracking Error - Because ETN payments at maturity are typically calculated based on index value and not on the value of any holdings, ETNs do not experience the same potential for tracking error as ETFs.

Investors should consider the investment objectives, charges, expense, and unique risk profile of an Exchange- Traded Note (ETN) carefully before investing. Leveraged and Inverse ETNs may not be suitable for all investors and may increase exposure to volatility through the use of leverage and other complex investment strategies. ETNs are subject to fluctuation in value including the potential for loss of principal. Investors should monitor these holdings consistent with their strategies, some as frequently as daily. A prospectus contains this and other information about the ETN and should be obtained from the issuer. The prospectus should be read carefully before investing.

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