Exchange-traded funds have been all the rage in recent years, providing all the benefits of index investing with greater tax efficiency and low, low fees. But investors need to be careful not to lump in their step-cousins, exchange-traded notes.
ETNs sound like the same thing but are very different, with both benefits and a unique set of risks.
“ETNs have greater credit risk than ETFs because ETNs don’t own any assets and are unsecured debt obligations,” says Kristin L. Regis of the finance faculty of Southern New Hampshire University in Manchester, New Hampshire.
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“These unsecured debt obligations are typically issued by banks and the creditworthiness of the issuer needs to be considered,” she says. “If the issuer goes bankrupt, the investor won’t get paid. Most large banks won’t fail (but) they certainly can.”
ETFs, like other funds, use investor money to buy assets like stocks and bonds, and shareholders then ride the portfolio’s ups and downs. ETNs are set up to track the performance of an underlying asset class but don’t actually own any securities. Instead the issuer, such as a bank, pledges to keep the ETN price aligned with the value of the linked assets.
ETNs cover a wide range of assets and can be useful for investors interested in non-mainstream holdings like futures contracts, Regis says. Other ETNs offer ways to bet on commodity futures in energy, grains, metals, livestock, and oil, or on foreign currencies or various stock sectors.
Like ETFs, ETNs are traded like stocks, allowing easy access throughout the trading day, and strategies like shorting, or betting that the value of the underlying index will fall.
ETNs are considered to be tax efficient because they do not have year-end capital gains distributions common among mutual funds, and even found with some ETFs. Nor do they pay out interest or dividends, as all gains are merely reflected in the share price and are therefore not taxed until after shares are sold.
ETNs appeal to investors who care about nitty-gritty details like tracking error, which is a discrepancy between a fund’s price and the index it follows. Because ETNs don’t actually own the assets they track, there can be no difference between their index and the “holdings” in their portfolio. Of course, tracking error matters mainly to investors who trade frequently and in very large volumes.
Major ETN issuers are banks like Barclays, BNP Paribas, Deutsche Bank and UBS.
What are the risks?
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“If the institution that issues it goes under, the investor would risk losing principal,” says J.J. Feldman, portfolio manager at Los Angeles-based Miracle Mile Advisors. “This would not happen with ETFs, as they can liquidate the underlying assets and pay back the investors.
Though the investor is wise to assess the issuer’s creditworthiness, which is not a concern with ETFs, that’s not an unusual task for anyone who has invested in bonds or bought insurance. ETN defaults are not common. Unlike bonds, ETNs are not rated individually, so the investor must assess the issuer’s rating.
“ETNs tend to be better for asset classes such as commodities,” Feldman says. “They also tend to be better for less liquid asset classes since they don’t have to own the underlying holdings.”
Certain ETNs can be used to bet on the stock market’s volatility by tracking the CBOE Volatility index, he adds. Some are leveraged to provide two to three times the market’s gains or losses.
He says that some ETNs, such as those tracking futures contracts, have high fees.
“Many of these vehicles are really short-term trading vehicles and not long-term investments,” Feldman says.
He says one of the most popular ETNs iPath S&P 500 VIX ST Futures ETN (ticker: VXX), which tracks the volatility of the Standard & Poor’s 500 index, has lost value in each of the past seven years, and is down nearly 60 percent this year despite overall gains for the S&P 500.
Betting on how extreme the market’s ups and downs will be is very different from betting on the market’s overall direction, so VXX is for speculators, not buy-and-hold investors. VXX has a 0.89 expense ratio, nearly 10 times the 0.09 percent charge by the SPDR S&P 500 ETF ( SPY), the exchange-traded fund tracking the S&P 500.
ETNs can be tricky at tax time, because many involve a Schedule K-1 to report partnership income that is unfamiliar to investors accustomed to 1099s, Feldman says.
So if you’re a hands-off, fire-and-forget investor accustomed to index funds and ETFs for retirement and college costs, stay away. ETNs are for a walk on the wild side.
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“My view is that ETNs can be useful trading tools, but are really not for the average retail investor,” Feldman says. “These products are more complicated to understand, and have far more risk than ETFs because they don’t actually own anything. They can be useful to gain exposure to commodities and certain other areas of the market, but generally if an investor is looking for stock exposure, ETFs are the way to go.”
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How to Buy Exchange-Traded Notes originally appeared on usnews.com
