Exchange-traded note(ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. It is part of structured notes family.  By the way, a structured note is an over the counter derivative with hybrid security features which combine payoffs from multiple ordinary securities, typically a stock or bond plus a derivative. A famous exemplary of such kind of products is CDS (credit default swap), which is similar to an insurance policy bet against the probability of financial catastrophes. John Paulson made a fortune by using CDS in the wake of financial crisis in 2008. ETN, in a sense, is similar to CDS that it allows investors to obtain the payoff based on the underlying index products.

According to the SEC, ” ETNs and ETFs are both traded on a securities exchange and can be bought and sold throughout the day, but there are important differences.  ETFs are registered investment companies.  An investor in an ETF owns shares of a fund, which represents an ownership interest in an underlying portfolio of assets.  An ETF discloses to investors the value of its portfolio of assets by publishing an end-of-day net asset value and by disseminating an estimate of its value generally every 15 seconds during the trading day, which is sometimes called an intraday indicative value.  An ETF issues and redeems its shares in creation units, at their net asset value.

ETNs share some characteristics with ETFs.  For example, ETNs also issue and redeem notes in creation unit sizes (generally, 25,000 to 50,000 notes); like with ETFs, the creation and redemption process affects the number of notes trading at any point in time.  For both ETNs and ETFs, the purchasers of the creation units split them up to sell the individual notes or shares, as applicable, to investors in transactions on an exchange.  But there is a fundamental difference between ETFs and ETNs.  Unlike ETFs, ETNs do not own an underlying portfolio of assets and this makes holders of ETNs subject to the creditworthiness of the issuer.  As ETNs do not own assets, when issuing new ETNs, ETN issuers calculate the value of the ETN using a described formula, rather than using net asset value.”

In essence, ETF is an asset created based on an index, whereas ETN is a debt note “gambled” against the performance of an index. The both allow open-trading via exchanges and both are tied to an index. However, there are certain aspects investors ought to heed caution on:

1.  Performance of the value of ETF vs. ETN. This can be illustrated with the following two formulas. So one can tell that ETN price is not only affected by the underlying components, but also creditworthiness of the issuers.

ETF Price = value of underlying investments + trading costs to create or redeem shares*
ETN Price = value of underlying index +default risk + supply of share

(*denotes the inability additional cost generated during the special redemption/creation of ETF units)

2.  Fee structure. From, it seems that both adopt the expense ratio to measure the cost and Average Spread (60-Day) for liquidity. Taking DBO (ETF) and OIL(ETN) as examples, they both attract over $300 million AuM, with an expense ratio of 0.75% and 0.78% respectively.

3.  Tax terms, ETF is quite straightforward, while ETN’s water is quite unclear yet.  There is no clear ruling on the tax treatment of ETN. In 2016, Congress proposed that ETN holders “mark-to-market” and pay on their paper gains.

So why clients, especially those ultra-wealthy clients at large banks prefer ETNs than ETFs? There are three reasons:

Even both ETF and ETN trying to provide a close tracking of the underlying indexes, ETN comes with an explicit promise while ETF fund manager never can make a full replication. Second, ETNs can be created on a bespoke/customized index created based on demands, so it offers an extraordinarily wide array of index options for clients to choose from. While ETF framework offerings are quite limited given the strict regulations and complex constructions along the way. Thirdly, ETNs don’t distribute a dividend or interest income the way a stock or bond fund may, so all taxes are deferred and taxed as capital gains. As alluded prior, there is no certain regulation of ETN tax terms yet, putting ETN a better option for wealthy clients in high tax bucket.



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