Exchange-traded notes (ETNs)

1. What is an ETN?

ETNs are not investment funds, but rather debt obligations issued by a bank. Like ETFs, they are bought and sold on an exchange. But instead of holding a basket of physical assets such as stocks or bonds, an ETN is simply a note that promises to pay investors a return based on the performance of a specific index or other benchmark.

2. The ETN advantage

There are four main advantages to using ETNs:

Tax efficiency: Since ETNs make no interest or dividend distributions, investors can defer paying tax on any gains until they sell the note

No tracking errors: Tracking an index is not as easy as it sounds, and most ETFs fall short of their benchmarks. However, the issuers of exchangetraded notes are obligated to deliver the total return of their indexes, minus only their fee, which is known to investors in advance.

Liquidity: Since ETNs are bought and sold on exchanges they are much more liquid than other structured investments. Investors can also track the performance of their ETN easily.

Access to specialized markets and strategies: ETNs provide retail investors with access to hard-to-reach market segments, such as commodities. Many also use leverage to increase exposure to their underlying indexes.

3. ETN risks

ETNs are subject to what is called counterparty risk—there is a possibility that the bank issuing the note will not honour the debt. “It sounds unlikely, but let’s not forget that before its collapse Lehman Brothers had issued ETNs in Europe,” says Richard Ferri, author of The ETF Book. Another consideration is the relatively high cost—often close to 1%.