Exchange Traded Notes Explained

What’s ETN

Unlike exchange traded fund (ETF), which has become a popular investment vehicle for investors who want both the broad diversification of a mutual fund and the flexible pricing and trading of a stock, exchanged traded note (ETN) is relatively new and little known. According to Investopedia, ETN is

A type of unsecured, unsubordinated debt security that was first issued by Barclays Bank PLC. This type of debt security differs from other types of bonds and notes because ETN returns are based upon the performance of a market index minus applicable fees, no period coupon payments are distributed and no principal protections exists.

Currently, the only ETN issuer is Barclays Bank, which also happens to be the largest ETF provider.

Difference between ETN and ETF

From the above definition, we know that ETNs are debt securities, not equities. Thus, like notes and bonds, a ETN has a maturity date. On the other hand, ETN also shares some common features with ETF, including:

  1. Both ETN and ETF are structured like a mutual fund that tracks an index;
  2. They are traded on exchanges like stocks.

The main difference is that, if held to maturity, Barclays promises to “repay the amount of your investment plus (or minus) the return of the index that the ETN tracks,” minus the note’s management fee, says an article, When exchange-traded notes make sense, in the July issue of Kiplinger’s Personal Finance magazine.

In terms of returns, since all the ETNs Barclays now offers have 100% correlation with their respective indexes, investors could get better return from ETNs if they hold the securities till maturity than from the ETF counterparts because, generally, ETFs guarantee at least 95% correlation with their underlying indexes.

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Is ETN the right investment?

The biggest benefit of ETN is, according to Barclays, that ETN doesn’t make taxable distributions. All the investment gains, such as dividends and interests, are lumped into the fund’s total return. Therefore, ETN investors will only face taxes at the time sell their shares, or redeem them when they mature. In this case, a favorable 15% tax rate will be applied for gains from shares held longer than one year, making ETNs a good choice for taxable investments.

As a new product, ETN has a very short history. The lack of tracking record could be a concern for investors who are considering adding ETNs to their portfolios. In addition, investor’s investments and any returns will depend on Barclays’ ability to deliver what it has promised to investors. Better pray the bank will still be around 30 years from now :) .

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9 Responses to “Exchange Traded Notes Explained”

  1. TFB |  Jul 18, 2007 at 1:49 pm

    “In terms of returns, since all the ETNs Barclays now offers have 100% correlation with their respective indexes, investors could get better return from ETNs if they hold the securities till maturity than from the ETF counterparts because, generally, ETFs guarantee at least 95% correlation with their underlying indexes.”

    This is not true. Correlation has very little to do with returns. You can have a security that vary a bit from the index from year to year, sometimes a little higher, sometimes a little lower, and in the end comes to the same value as the index after 30 years. Or you can have two securities with a big difference in returns but have near 100% correlation between the two. Just try it in Excel. Do one series with 10% increase every year, another series with 7% increase every year, then use the CORREL function on them.

  2. Sun |  Jul 18, 2007 at 7:45 pm

    TFB: What I want to say actually is that since ETN is 100% correlated with the index, investors will get whatever the return the index has. For ETF that tracks the same index, however, the 95% correlation could result in a better performance, and it could lead to slightly inferior result as well. Over the long term, as you said, if ETF’s performance fluctuates around the index, then the average return could be the same as the index. However, if ETF is consistently underperform its benchmark by even 0.1%, its long term performance cannot be better than ETN’s.

  3. Acero |  Jul 18, 2007 at 9:27 pm

    Hey Sun, read your blog for a long time, only lurked until now. You certainly have a lot of good work going on here, interesting with every post.

    Do you have any business notes yourself, not ETNs but actual notes? I was reading about them awhile back and senior secured notes, such as the ones that RiteAid put out a few months ago at 10% or better seemed like a interesting investment vehicle. Not 100% safe, but what is? Only reason I did not invest is that I couldn’t find any way for an individual to buy them. Any thoughts on this type of investments?

  4. choobro |  Jul 20, 2007 at 9:37 am

    TFB: what you said is very true but you left out one minor detail. Over the long term the ETF that tracks similar to an index will out perform an ETF mirroring an index when you adjust for costs. The bying and selling costs associated with a fund trading enough to mirror the weighting in the index it is tracking would eat into the investors return. By simply getting close to the index they find a healthy balance.

  5. Sun |  Jul 23, 2007 at 1:14 am

    choobro: I feel that any fund that tracks an index, whether it’s tracking or mirroring, will have to engage in buy and sell if the fund’s performance wants to be measured by that index. Tracking won’t necessarily make the adjustments smaller or infrequent than mirroring.

  6. Laura Shelting |  Nov 30, 2007 at 11:23 am

    Merrill Lynch now offers Exchange Traded Notes as well as Barclays iShare.