Exchange-Traded Notes: The Facts and the Risks

While ETNs are sometimes grouped alongside ETFs, the big umbrella term that covers both of them is ETP: exchange-traded product.

An exchange-traded fund (ETF) is a basket of securities such as stocks, bonds or commodities. It's similar in many ways to a mutual fund, but it trades on an exchange like a stock. An important characteristic of ETFs and mutual funds is that they're legally separate from the company that manages them. They're structured as separate "investment companies," "limited partnerships" or "trusts." This matters because even if the parent company behind the ETF goes out of the business, the assets of the ETF itself are completely separate and investors will still own the assets held by the fund.

Exchange-traded notes (ETNs) are different. Instead of being an independent pool of securities, an ETN is a bond issued by a large bank or other financial institution. That company promises to pay ETN holders the return on an index over a certain period of time and return the principal of the investment at maturity. However, if something happens to that company (such as bankruptcy) and it's unable to make good on its promise to pay, ETN holders could be left with a worthless investment or an investment that is worth much less (just like anyone who had lent the company money).

Another important difference between ETFs and ETNs is that ETNs (unlike ETFs) are not overseen by a board of directors who are tasked with looking out for investors. Instead, decisions about the management of an ETN are determined solely by the issuer based on the rules they've laid out in the ETN's prospectus and pricing supplements. In some cases, the issuers of ETNs may engage in proprietary trading or hedging activities in their own accounts that are contrary to the interests of ETN investors.

Given that ETNs carry credit risk and are not overseen by a board of directors, you might wonder why anyone uses them at all. But there are a few features that attract some investors to ETNs.

First, since the issuer is promising to pay exactly the return on an index (minus its own expenses, of course), there's little risk of tracking error. That is, the ETN should be expected to very closely match the performance of the index. Of course, well-managed ETFs can do the same thing, but an ETN comes with an explicit promise.

Second, some ETNs promise to deliver the returns of a particular index that isn't available in an ETF framework. For investors committed to such a niche investment, an ETN might be the only option.

Third, ETNs may have some attractive tax consequences. While this could change in the future, ETN investors typically pay taxes on their investment only when they sell it for a gain or when the ETN matures (or is called by the issuer). ETNs don't distribute dividend or interest income the way a stock or bond fund may, so most taxes are deferred and taxed as capital gains. However, ETNs based on foreign currencies are an exception. The gains on these ETNs are taxed as ordinary income.

Credit risk: ETNs rely on the credit worthiness of their issuers, just like unsecured bonds. If the issuer defaults, an ETN's investors may receive only pennies on the dollar or nothing at all, and investors should remember that credit risk can change quickly. At the time of its bankruptcy in September 2008, Lehman Brothers had 3 ETNs outstanding. While many investors sold these ETNs prior to Lehman's collapse (only $14.5 million remained in the 3 ETNs when the firm folded), investors who didn't get out received just pennies on the dollar.¹

Liquidity risk: The trading activity of ETNs varies widely. For ETNs with very low trading activity, bid-ask spreads can be exceptionally wide.  For example, in April 2023 one ETN had an average spread of 12.5%!²

Issuance risk (aka volatile premiums): Unlike ETFs where the supply of shares outstanding fluctuates in response to investor demand, ETNs are created only by their issuers who are effectively issuing new debt each time they create additional units. At times, issuers may be unable to create new notes without violating the capital requirements set by bank regulators. Furthermore, banks often set internal limits on the amount of risk they are willing to assume from ETNs, and issuers have ceased to issue new notes which have become too large or too expensive to hedge.³ Investors who purchase ETNs at a premium (in other words, pay a higher price than the value of the note based on the performance of the underlying index or referenced asset), are at risk of losing money when issuance resumes and the premium dissipates, or if the note is called by the issuer who returns only the indicative value.

For example, consider one highly exotic ETN (TVIX) that was designed to track twice the daily returns of an index of futures contracts on the implied volatility of the S&P 500^® Index. On February 21, 2012, the underwriting bank behind the note decided to stop issuing new shares of the ETN. This meant that as more investors tried to buy the note supply wasn't keeping up with demand, and the note's price began increasing by much more than its indicative value. By March 21, 2012, the ETN's market price was almost 90% higher than its underlying indicative value. On March 22, 2012, when the underwriting bank announced that it would once again start issuing new shares, the ETN's price began its steep descent back to reality. The ETN's price plunged almost 30% in one day and almost 30% again the next day, ending the two-day stretch with a price only 6% higher than the fund's indicative value.⁴

Closure risk: There are multiple ways for an issuer to effectively close an ETN. An issuer may call the note (also known as "accelerated redemption") by returning the value of the note less fees. However, not all ETNs have terms in their prospectuses or pricing supplements which allow for accelerated redemption. A much less friendly alternative is for issuers to delist the note from national exchanges and suspend new issuance. When this happens, ETN investors are left with a pretty unpleasant choice. They can either hold the note until it matures, which could be up to 40 years away, or trade the ETN in the over-the-counter (OTC) market where spreads can be even wider than on national exchanges. Recognizing the problem this may create for investors, some issuers have attempted to create a more note-holder friendly alternative by offering to buy back ETNs directly through tender offers.

For many years, we've felt that the credit risk inherent in an ETN isn't worth it. Most investors turn to exchange-traded products in order to get exposure to a particular segment of the market, not to evaluate a bond issuer's health or to delve into the business consideration that issuers make when deciding to launch or continue supporting an ETN. As a result, investors may find ETNs to be more trouble than they are worth.

If you still think an ETN might make sense for your portfolio, we encourage you to first check out an alert issued in July 2012 by The Financial Industry Regulatory Authority (FINRA) to inform investors of the features and risks of ETNs: "Exchange-Traded Notes—Avoid Unpleasant Surprises."