Exchange-traded note

Last updated

An exchange-traded note (ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank or by a special-purpose entity. [1] [2] Similar to other debt securities, ETNs may have a maturity date and are backed by the credit of the issuer, though some ETNs may have a portfolio of assets given as a collateral. [3]

Contents

ETNs are designed to provide investors access to the returns of various market benchmarks. The returns of ETNs are usually linked to the performance of a market benchmark, a so-called market-linked note , or to the performance of an active investment strategy, in this case being called an actively managed certificate [4] or performance-linked bond. [5] In all cases, the returns are net of expenses and management fees.

When an investor buys an ETN, the issuer promises to pay the amount reflected in the index net of expenses and fees upon maturity (though in some cases the ETN may be perpetual, and the investor will get their investment back by selling it in the secondary markets). Thus an ETN has an additional risk compared to an exchange-traded fund (ETF); if the credit rating of the issuer is compromised, the investment might lose value in the same way that a senior debt would. [6]

Often linked to the performance of a market benchmark, ETNs are not equities, equity-based securities, index funds or futures. Although ETNs are usually traded on an exchange and can be sold short, owners of ETNs don't actually own any underlying assets of the indices or benchmarks they are designed to track.

The first ETN across the globe was developed and issued in May 2000 in Israel by Haim Even-Zahav the CEO of Psagot-Ofek financial instruments (Leumi group) under the product name TALI-25. [7] [ failed verification ] The purpose of issuing this instrument was to track the TEL AVIV-25 index which represent the 25 leading companies in Israel.

Structure

The returns of ETNs are linked to the performance of a market benchmark or strategy, less investor fees.

As discussed previously, ETNs are debt notes. When held to maturity, the investor will receive a cash payment that is linked to the performance of the corresponding index during the period beginning on the trade date and ending at maturity, less investor fees. Typically, ETNs do not offer principal protection.

ETNs could also be liquidated before their maturity by trading them on the exchange or by redeeming a large block of securities directly with the issuer. A redemption charge may apply, subjected to the procedures described in the relevant prospectus.

The investor fee is calculated cumulatively based on the yearly fee and the performance of the underlying index and increases each day based on the level of the index or currency exchange rate on that day. Because the investor fee reduces the amount of return at maturity or upon redemption, if the value of the underlying decreases or does not increase significantly, the investor may receive less than the principal amount of investment at maturity or upon redemption.

Since ETNs are unsecured, unsubordinated debts, their risk is that of bonds of similar priority in the company's capital structure. Often issued off medium-term note shelves, ETNs would be pari passu with other debt issued off the same shelf. Therefore, ETNs are backed by the credit of the underwriting issuer. Like other debt securities, ETNs do not have voting rights. Unlike other debt securities, interest is not paid during the term of most ETNs.

Advantages

Tax efficiency

An ETN offers a tax-efficient way to invest. It is treated as a prepaid contract (such as a forward contract) for tax purposes. The buyer of a prepaid contract pays an initial amount in order to receive a future payment based on the value of an index or other underlying benchmark at a specified future time.

Very often index mutual funds and ETFs are required to make yearly income and capital gains distributions to its fund holders that are taxable. When a fund is forced to sell stock to rebalance or otherwise change its composition, the fund holders have to pay any resulting capital gains tax.

With ETNs, in contrast, there is no interest payment or dividend distribution, which means there is no annual tax. Capital gain (or loss) is realized when an investor sells the ETN or it matures. Long-term capital gains are treated more favorably than short-term capital gains and interest in the US (> 1 year holdings are taxed at a capital gains rate of 20%). There is no way to avoid paying capital gains tax, but there can be great advantage in wealth building by delaying it.

Recent tax rulings have suggested that ETNs may be qualified tax shelters for the purpose of changing current interest income into deferred capital gains income. [8]

No tracking error

ETNs give investors a broad-based index without any tracking error to the index, [9] doing away with the discrepancies that exist between the returns of many ETFs and their underlying indexes. One reason of the tracking error observed in ETFs might be attributed to the diversification issues that stem from the inability of a fund to replicate an index due to an upper limit on the maximum asset allocation to a single stock. But for ETN, this constraint does not exist, because though ETN is also tracking the index, the return is not based on the underlying securities. The ETN issuer guarantees the holder a return that is an exact replica of the underlying index, minus expense fees. The bank also agrees to pay large shareholders the exact value of the note on a weekly basis through redemption, which helps the ETNs track very closely to the underlying index return.

Liquid structured product

ETNs are a significant innovation to improve liquidity of structured products. Unlike other buy-and-hold structured products, ETNs can be bought and sold during normal trading hours on the securities exchange. For institutional size redemption, investors may offer their ETN for repurchase by the issuer on a weekly basis. Investors can easily track the performance of their ETN. In this sense, ETNs are structured to resemble ETFs. But ETNs are different from ETFs, as they consist of a debt instrument with cash flows derived from the performance of an underlying asset – a structured product.

Access to new markets and strategies

ETNs have provided access to hard-to-reach exposures, such as commodity futures and the Indian stock market. [10] [11] [12] Certain asset classes and strategies are not easily accessible to individual investors. For example, the momentum investing strategy, which is used in SPECTRUM Large Cap U.S. Sector Momentum Index, is to take advantage of the varied performances of the 10 sub-indexes of the S&P 500 Total Return IndexSM (SPTR) relative to each other and to the SPTR. The weights of the 10 sub-indexes are computed each day based on performance and correlation. This makes SPECTRUM Large Cap U.S. Sector Momentum Index difficult to track through ETF. On the contrary, ETN provides opportunities to gain exposure to these types of investment strategies in a cost-efficient way.

Possibility of leverage

Some of the ETNs offer leverage instead of directly tracking a benchmark's performance. [12] For instance, the DGP ETN offered by Deutsche Bank moves in the same direction as gold, but involves double leverage - it replicates twice the returns of holding gold. If gold gains 1%, the note gains 2%. Consequently, if gold goes down by 1%, the note loses 2%. [13] Such characteristics make ETNs suitable for experienced investors willing to take on additional risk in hope of a higher return.

Disadvantages

Credit risk & lack of risk metrics

ETNs, as debt instruments, are subject to risk of default by the issuing bank as counter party. [14] [10] This is the major design difference between ETFs and ETNs: ETFs are only subject to market risk whereas ETNs are subject to both market risk and the risk of default by the issuer. [6] Even though the possibility of default turning into a reality is relatively low, it ought to be measured and accounted for. [15] Given that good risk management practices involve measuring the level of credit risk of an investment that is subject to such a risk, [16] the lack of a centralised credit risk database for ETN issuers may pose a challenge to making the ETN market fully developed, especially in the case of ETNs that are not issued by banks.

Illiquidity

ETNs have less trades at the secondary market than ETFs. [17] Hence, they are naturally more illiquid.

Tax benefits speculative

The ETN issuers are using tax efficiency as their trump card. As things stand, there is significant tax saving to be gained from investing in ETNs. In reality, however, the Internal Revenue Service has yet to decide on the proposed tax treatment. So, the tax benefit status is still arguable. [17]

Dependence on credit ratings

ETNs have their worth decided by two factors:

Suppose the issuing bank has been impacted negatively, if only marginally, by a crisis like the 2008 subprime mortgage crisis and the ratings agencies depreciate the overall credit rating of the issuer to reflect the event. In this hypothetical case, even though the index it is tracking is showing growth, a decline in rating of an ETN issuing financial institution could negatively impact the worth of an ETN. [18]

Unprofitable trading strategies

The S&P GSCI has lost nearly 20% of its value since January 2006, despite soaring commodity prices, all thanks to contango. This is one instance where ETN tracked commodity indices like GSCI have ended up doing exactly the opposite of what they had set out to do.

The UBS Bloomberg Constant Maturity Commodity Index (CMCI) addresses the issues of contango and backwardation by introducing the concept of constant maturity, which provides diversification across futures contract maturity dates. This is intended to smooth out the volatility often associated with commodity investments. [19]

See also

Related Research Articles

Passive management is an investing strategy that tracks a market-weighted index or portfolio. Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.

<span class="mw-page-title-main">Commodity market</span> Physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Futures contracts are the oldest way of investing in commodities. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

An index fund is a mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that it can replicate the performance ("track") of a specified basket of underlying investments. While index providers often emphasize that they are for-profit organizations, index providers have the ability to act as "reluctant regulators" when determining which companies are suitable for an index. Those rules may include tracking prominent indices like the S&P 500 or the Dow Jones Industrial Average or implementation rules, such as tax-management, tracking error minimization, large block trading or patient/flexible trading strategies that allow for greater tracking error but lower market impact costs. Index funds may also have rules that screen for social and sustainable criteria.

A mutual fund is an investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV in Europe, and the open-ended investment company (OEIC) in the UK.

In finance, a convertible bond, convertible note, or convertible debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. It originated in the mid-19th century, and was used by early speculators such as Jacob Little and Daniel Drew to counter market cornering.

An exchange-traded fund (ETF) is a type of investment fund that is also an exchange-traded product, i.e., it is traded on stock exchanges. ETFs own financial assets such as stocks, bonds, currencies, debts, futures contracts, and/or commodities such as gold bars. Many ETFs provide some level of diversification compared to owning an individual stock.

A credit-linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider.

A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a desk will employ a specialized "structurer" to design and manage its structured-product offering.

A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds.

The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. Investors frequently use the index as a stand-in for measuring the performance of the US bond market.

Gold exchange-traded products are exchange-traded funds (ETFs), closed-end funds (CEFs) and exchange-traded notes (ETNs) that are used to own gold as an investment. Gold exchange-traded products are traded on the major stock exchanges including the SIX Swiss Exchange, the Bombay Stock Exchange, the London Stock Exchange, the Paris Bourse, and the New York Stock Exchange. Each gold ETF, ETN, and CEF has a different structure outlined in its prospectus. Some such instruments do not necessarily hold physical gold. For example, gold ETNs generally track the price of gold using derivatives.

An equity-linked note (ELN) is a debt instrument, usually a bond issued by a financial institution such as an investment bank or a subsidiary of a commercial bank. ELNs are liabilities of the issuer, but the final payout to the investor is based on an unrelated company's stock price, a stock index or a group of stocks or stock indices. The underlying stocks typically have large market capitalizations. Equity-linked notes are a type of structured product and are often marketed to unsophisticated retail investors.

The following outline is provided as an overview of and topical guide to finance:

A reverse convertible security is a type of convertible security where a bond or short-term note can be converted to cash, debt or equity at a set date by the issuer based on an underlying stock. In effect it is a type of option on the maturity date where the bond can be converted to shares or cash. For the investor they get the advantage of a steady stream of income due to the payment of a high coupon rate, but will either get back their principle or a predetermined number of shares in the underlying stock if they are lower. The coupon rate is typically higher because the investor participates in the risk that the underlying shares are lower at the maturity date.

An exchange-traded product (ETP) is a regularly priced security which trades during the day on a national stock exchange. ETPs may embed derivatives but it is not a requirement that they do so – and the investment memorandum should be read with care to ensure that the pricing methodology and use of derivatives is explicitly stated. Typically, individual underlying securities, such as stocks and bonds, are not considered ETPs.

Alerian, is an American company that provides transparent master limited partnerships (MLP) and energy infrastructure benchmarks and analytics. The flagship Alerian MLP Index (AMZ) is used by industry professionals to analyze relative performance.

In finance, the iPath refer to a family of exchange-traded notes (ETN) issued by Barclays. iPath ETNs are senior, unsecured debt securities of Barclays Bank PLC, covering the following asset classes: Commodities, Equity smart beta, MLPs, Sustainable investing, and Volatility.

<span class="mw-page-title-main">Investment fund</span> Way of investing money alongside other investors

An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages include an ability to:

References

  1. ↑ Wright, Colby; Diavatopoulos, Dean; Felton, James (May 31, 2010). "Exchange-Traded Notes: An Introduction". The Journal of Investing. 19 (2): 27–37. doi:10.3905/joi.2010.19.2.027. ISSN   1068-0896. S2CID   154552351.
  2. ↑ Rakowski, David; Shirley, Sara (February 2020). "What Drives the Market for Exchange-Traded Notes?". Journal of Banking & Finance. 111: 105702. doi:10.1016/j.jbankfin.2019.105702. ISSN   0378-4266.
  3. ↑ Rose, Gordon (June 7, 2011). "Understanding Exchange-Traded Commodities & Notes". Morningstar . Retrieved June 24, 2024.
  4. ↑ Prochazkova, Linda (May 23, 2019). "The New Generation of Actively Managed Certificates". Julius Baer . Retrieved June 21, 2024.
  5. ↑ "British Vertical Fintech Uses AI to Create a Low-Cost Investable Product". Gulf News . Retrieved June 21, 2024.
  6. 1 2 Rati, Victoria (November 2012). "An Empirical Analysis of Exchange-Traded Funds". CFA Digest. 42 (4): 153–156. doi:10.2469/dig.v42.n4.79. ISSN   0046-9777.
  7. ↑ "Tali25". BankLeumi.co.il. Archived from the original on July 17, 2019.
  8. ↑ Sloan, Allan (December 7, 2007). "An Investment That Keeps Giving". Fortune. New York: Cable News Network. Archived from the original on October 22, 2012.
  9. ↑ Aroskar, Rajarshi; Ogden, Willaim A. (June 21, 2012). "An Analysis of Exchange-Traded Notes Tracking Errors with Their Underlying Indexes and Indicative Values". Applied Financial Economics. 22 (24): 2047–2062. doi:10.1080/09603107.2012.684787. ISSN   0960-3107. S2CID   153329619.
  10. 1 2 Rakowski, David; Shirley, Sara (February 2020). "What Drives the Market for Exchange-Traded Notes?". Journal of Banking & Finance. 111: 105702. doi:10.1016/j.jbankfin.2019.105702. ISSN   0378-4266.
  11. ↑ Higgins, M.; MacNamee, C.; Mullane, B. (2008). IEEE 1500 Wrapper Control Using an IEEE 1149.1 Test Access Port. IET Irish Signals and Systems Conference (ISSC). IEE. pp. 198–203. doi:10.1049/cp:20080662. ISBN   978-0-86341-931-7.
  12. 1 2 Rakowski, David; Shirley, Sara E.; Stark, Jeffrey R. (December 2017). "Tail-Risk Hedging, Dividend Chasing, and Investment Constraints: The Use of Exchange-Traded Notes by Mutual Funds". Journal of Empirical Finance. 44: 91–107. doi:10.1016/j.jempfin.2017.08.003. ISSN   0927-5398.
  13. ↑ Radomski, Przemyslaw. "How to Buy: ETNs". Sunshine Profits. Retrieved November 14, 2012.
  14. ↑ Cserna, Balazs; Levy, Ariel; Wiener, Zvi (June 30, 2013). "Counterparty Risk in Exchange-Traded Notes (ETNs)". The Journal of Fixed Income. 23 (1): 76–101. doi:10.3905/jfi.2013.23.1.076. ISSN   1059-8596. S2CID   155764796.
  15. ↑ "Exchange-Traded Notes—Avoid Unpleasant Surprises".
  16. ↑ "How to Quantify Credit Risk". Investopedia. Retrieved June 22, 2024.
  17. 1 2 "ETF vs. ETN: What's the Difference?". Investopedia. Retrieved June 23, 2024.
  18. ↑ "Investor Bulletin: Exchange Traded Notes (ETNs)". SEC.gov.
  19. ↑ "UBS ETNs Seek to Smooth Out Commodity Ride". Seeking Alpha.
This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.