ETN Basics
ETNs are registered as debt instruments that pay a return linked to the performance of a single security or index
The operating structure of ETNs is particularly suited for specialized asset classes such as commodities and emerging markets. ETNs are typically registered under the Securities Act of 1933.
Familiar Features
Comparing ETFs and ETNs will reveal many similarities. For example, ETFs and ETNs track commodity, currency, and equity market indexes. Also, ETNs are bought and sold with a traditional brokerage account just like ETFs.
Another similar feature is that ETNs have an arbitrage feature that's designed to keep market prices closely hinged to the intrinsic value of the benchmarks they track. Investors that accumulate large blocks of notes (usually 50,000 or more) can redeem them back to the issuing financial institution on a weekly basis in order to take advantage of any pricing discrepancies that may exist. The redemption feature of ETNs is intended to reduce the possibility of notes trading at steep premiums or discounts.
Liquidity Options
Investors that opt to keep their ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. Applicable fees are deducted and can reduce the value of the payment. Maturity periods can vary and may be as long as 30 years. ETN investors are not required to hold their note to maturity. ETNs can be sold prior to maturity on the exchange where they trade or they can be redeemed in large blocks.
ETNs and Taxes**
Under the current tax law, commodity and equity linked ETNs are taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption, or maturity of their note. If held to maturity, the future payment of the contract is dependent on the value of the underlying benchmark index.
In December 2007, the U.S. Internal Revenue Service issued an adverse tax ruling on currency linked ETNs. The rule stated that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells any such financial instrument, including an ETN, or the contract, matures. It also means that gain or loss on sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment. The IRS is expected to rule on the tax treatment of ETNs linked to commodities and stocks.
Calculating the Indicative Value of an ETN
As debt securities, ETNs do not trade at or have a net asset value (NAV). Their daily indicative value is based upon the index level which is published daily by an index provider or media outlet. The purpose of calculating the indicative value of an ETN is to approximate the intraday economic value of the note. (See the equation below.)
Indicative Value = Principal Amount per Unit x Current Index Level/Initial Index Level minus Current Investor Fee
ETFs vs. ETNs
Exchange-Traded Funds (ETFs)
Exchange-Traded Notes (ETNs)
Continuous trading and pricing throughout the day?
Yes
Yes
Can be purchased through a traditional brokerage account?
Yes
Yes
Can they be bought on margin?
Yes
Yes
What recourse do investors have?
Portfolio of Securities
Issuer Credit
Can they be shorted?*
Yes, on an uptick or a downtick
Yes, on an uptick or a downtick.
What are the risks to principal?
Market Risk
Market and Issuer Risk
How are they registered?
Investment Company Act of 1940
Securities Act of 1933
*With short sales, you risk paying more for a security than you received from its sale Source: ETFguide.com
**Always consult your tax advisor for specific tax information as it pertains to you.
