Exchange-traded note

An exchange-traded note (or ETN) is a senior, unsecured, unsubordinated debt security issued by an underwriting bank. Similar to other debt securities, ETNs have a maturity date and are backed only by the credit of the issuer.

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 or strategy, less investor fees. When an investor buys an ETN, the underwriting bank promises to pay the amount reflected in the index, minus fees upon maturity. Thus ETN has an additional risk compared to an ETF - upon any reduction of credit ratings or if the underwriting bank goes bankrupt, the value of the ETN will be adversely eroded.

Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted. Similar to index fund, they are linked to the return of a benchmark index. But as debt securities, ETNs don't actually own anything they are tracking.

The first ETN, marketed as the iPath Exchange-Traded Notes, was issued by Barclays Bank PLC on 12 June 2006. This was soon followed by Bear Stearns, Goldman Sachs & Swedish Export Credit Corp. In 2008, additional issuers entered the market with their own offerings; these include BNP Paribas, Deutsche Bank, UBS, Lehman Brothers, Morgan Stanley and Credit Suisse. As of April 2008, there were 56 ETNs from nine issuers tracking different indexes. The popularity of ETNs is mainly due to the advantages that it offers to investors.

tructure of ETNs

The returns of ETNs are linked to the performance of a market benchmark or strategy, less investor fees. Currently, there are four types of ETNs, Commodity ETNs, Emerging Market ETNs, Currency ETNs and Strategies ETNs available in the market. (Please refer to Appendix A for a list of available products in each category.)

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 to the issuing bank. The redemption is typically on a weekly basis and 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, they are not rated, but are backed by the credit of underwriting banks. Like other debt securities, ETNs do not have voting rights. But unlike other debt securities, interest will not be paid during the term of the most ETNs.

Pros and Cons of ETNs

Advantages

Tax efficiency

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

Very often index mutual funds and ETFs are required to make yearly income and capital gains distributions to fund holders which are taxable. Meanwhile, for ETF, when a fund is forced to sell stock to change its composition, for example, when an index rebalances, the fund holders have to pay tax on whatever the capital gain was, when the stock is sold.

In contrast, for ETN, there is no interest payment and dividend distribution, so neither is there a tax. The timing of the realization of gains or losses on their ETN is based on when investors buy and sell their investment. Since the entire gain is treated as a capital gain, the investor can defer any gain until the security is either sold or it matures. Because long-term capital gains are treated more favorably (Holding more than 1 year, all the gains will be taxed as long-term gains at 15%) than short-term capital gains and interest, the tax treatment of ETNs should be more favorable than that of ETFs. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid as tax can continue to accumulate wealth. Control over the timing of this capital gain is a big benefit to any investor looking to defer the payment of income taxes.

Recent tax rulings have additionally suggested that ETNs may be qualified tax shelters for the purpose of changing current interest income into deferred capital gains income. [http://money.cnn.com/2007/11/25/news/companies/sloan_barclays.fortune/?postversion=2007112608]

No tracking error

ETNs give investors a broad-based index without any tracking error to the index, 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 constrain 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

ETN is a significant innovation to improve liquidity of structured products. Not like other buy-and-hold structured products, ETN 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, ETN is structured to resemble ETF. But ETN is different from ETF, 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. 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.

Disadvantages

Credit Risk & Lack of Risk Metrics

ETNs, as debt instruments, are subject to risk of default by the issuing bank as counter party. Even though the possibility of default turning into a reality is relatively low, it ought to be measured and accounted for. ETN investors will require a credit risk metric that facilitates answer to questions regarding the magnitude of the risk and its variation with time. With new players foraying into the ETN space, how will the risk vary by issuer? Who will take up the risk evaluation process? If and when the ETN sector grows, in order to partcipate, retail and institutional investors will need a source for ETN key data which is easy to assimilate.

Illiquidity

Given its relative newness, there is a flurry of ETNs hitting the market. They are, however, yet to engage the market players enthusiastically, several of whom are probably opting for the wait and watch approach. Under such circumstances, the liquidity of the notes in the secondary markets may be threatened should they fail to gain sufficient trading momentum. The effectiveness of ETNs at tracking indices is contingent on their ability to garner enough support in the market.

Another flipside of ETNs relates to their redemption feature. While ETNs can be sold daily on the secondary markets or held until maturity, institutional investors who wish to redeem blocks of 50,000 units or more directly with the issuer can only do so once a week. In contrast, other structured products, ETFs for instance, can be redeemed anytime during a trading day.

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 is yet to decide on the proposed tax treatment. So, the tax benefit status is still arguable.

Dependence on credit ratings

ETNs have their worth decided by two factors:

• Performance of the index they are set to track

• Credit ratings of the issuer

Suppose the issuing bank has been impacted negatively, if only marginally, by a crisis like the recent (2007-2008) subprime mortgage turmoil and the ratings agencies depreciate the overall credit rating of the issuer to reflect the event.

In the aforementioned set-up, even thought the index it is tracking is showing growth, a decline in rating of an ETN issuing financial institution could negate the worth of an ETN.

Unprofitable trading strategies

The 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.

Contango is a scenario where the cost of the next-month futures contract is costlier than the current month contract. In this event, the issuing bank books a loss each time a current month contract is sold and the next month contract is bought. Contango has hit hard the energy futures over the past few years and markedly brought down the returns from energy markets.Indices are taking varied steps to hedge against the condition. Their results remain to be seen though.

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. [ [http://seekingalpha.com/article/71754-ubs-etns-seek-to-smooth-out-commodity-ride UBS ETNs Seek to Smooth Out Commodity Ride] ]

Prospect and Conclusion

As a new product, ETN has a very short history. However, it has been growing very rapidly. The ETN represents a nifty product structure that is gaining respect and funding in the market. By 18 July 2006, just one month after the launch of first two ETNs, GSP and DJP, GSP had attracted more than $40 million in assets, and DJP had pulled in more than $130 million for Barclays. Investments in iPath ETNs surpassed $2 billion by late April 2007. In just over a year Barclays has gathered close to $3 billion in eight funds. Encouraged by the good performance of the ETNs launched by Barclays, other financial institutions have either launched their own products or are drawing plans to partake of the ETN space. We believe more ETNs will be launched to raise more equity for financial institutions. For the customers, the advantages such as tax-efficiency and good liquidity of ETNs will attract more investors to this innovative structured product. All of these imply that ETN is becoming more and more popular.

However, now the question is whether this trend is going to last long. Several industry gurus point to factors that may well dampen the initial euphoria surrounding this product of financial engineering. The lack of historical record – upon which to base their decision to make ETN a part of their portfolio or not – could be keep potential investors at bay. More importantly, the issuing banks advertise tax-efficiency as ETNs USP. If the IRS rules in the issuers’ favor, the implications of which have been discussed at length in Chapter 3, ETN sales could explode. But what if the IRS delivers an unfavorable word-or never rules? A line of thought that is doing rounds is that even if the IRS delivers an unfavorable word-or never rules at all-the ETNs could still be enormously successful. The reason is that ETNs provide efficient access to segments of the market that would otherwise be difficult for retail investors to reach. But how could we expect that the investors would still prefer ETNs to ETFs, or any of the multitudes of other structured products out in the market, if there is no tax-efficiency for ETNs. Drawing a comparison to ETFs, another structured product, which suffers from only market risk, ETNs face both counter party risk and market risk. ETNs, bereft of their tax advantage, may lose their shine in the eyes of an entire class of investors.

To conclude, ETNs have performed very well so far as a new kind of structured product with lower fees, better liquidity and tax-efficiency. However, both financial institutes and investors should keep an eye the status of the tax opinion from the IRS on ETNs while seeking ETNs as business or investment possibility.

Notes

ee also

*Exchange-traded fund
*Structured products

External links

* [http://etf.seekingalpha.com/article/43585 The ETN Market Heats Up With Goldman Launch; More On the Way]
* [http://online.wsj.com/public/article/PR-CO-20070720-902362-QRFrslYyTs_KIqGI0RI_kuw1Hx4_20080811.html?mod=crnews Bear Stearns Launches BearLinx(SM) Exchange Traded Note Linked to the Alerian MLP Select Index]
* [http://etf.seekingalpha.com/article/13750 Barclays Files for Exchange Traded Note for Oil - How It Differs From The ETF]
* [http://www.etncenter.com/ ETN Index, News and Education]