Exchange-traded notes (ETNs)—a distant relative to the wildly popular exchange-traded funds (ETFs)—are in the news recently, mostly spurred by Credit Suisse’s delisting1 of two heavily traded securities: VelocityShares 3x Long Crude Oil ETN (UWTI) and the VelocityShares 3x Inverse Crude Oil ETN (DWTI). The Wall Street Journal2 also reports that more ETN delistings could be on the way.
Holders of these securities may be understandably concerned about the possible impact of these recent changes on their portfolios. And with the growing popularity of both ETFs and ETNs alike, more and more investors may have these vehicles on their radar as a potential investment. Further, some may be inclined to think that ETFs and ETNs are similar: Both represent baskets of underlying products and both can be bought and sold like common stock.
But in fact they are very different.
ETFs allow investors to take positions in baskets of underlying securities or commodities, and are backed by the underlying assets. For example, if you buy shares of an S&P 500® ETF, you are investing in a fund that has purchased a basket of stocks that comprise the S&P 500. As such, the fund is entitled to the same rights afforded to regular shareholders. Similarly, if you own a commodity ETF like GLD, you actually indirectly own an underlying portion of the physical gold, which is held by a trust.
ETNs, on the other hand, are structured products issued as subordinated debt by an institution, typically a bank, which seek to provide the buyer the performance of an index or commodity. This means that the investor doesn’t actually invest in the underlying assets like ETFs. The potential upshot here is that, come tax season, savings may be found—since an ETN doesn’t buy and sell assets like an ETF, traders can potentially avoid short-term capital gains taxes. With the GLD ETF, for example, investors physically own the underlying precious metal through a trust—taxed as a collectible—which translates to a long-term capital gains rate of 28%.
While ETNs provide some appealing investment characteristics, they also come with three key considerations that can prove challenging for holders:
- Many are high maintenance. Since many of these securities use leverage, along with derivatives that have maturity dates, they require daily monitoring and upkeep as they may lose value quickly as a result of leverage decay. Translation: These securities are rarely held overnight, as they need to be reset and rebalanced on a daily basis in order to maintain a certain leverage ratio. For this reason, ETNs are best suited for short-term trading.
- They present issuer risk. When you buy an ETN, you’re buying debt, which means that a buyer assumes the risk that the issuer may default. Because an ETN is a debt instrument, if the issuer defaults, the investor has to stand in line with all of the other creditors and hope that they can get some of their money back.
- They can be hard to trade in tough times. And while these products generally trade without issue on an exchange, an unexpected closure or delisting can be a headache for investors looking to exit their position. As debt instruments, ETNs have maturity dates. When an ETN delists, investors still hold the note and will be paid at the expiration, but it is much harder to buy and sell that debt beforehand. In the case of the UWTI, for example, holders of the ETN won’t be able to cash them in until 2032.1 While in the past they could trade the ETN on the New York Stock Exchange, now they will have to trade it over-the-counter. The less liquid over-the-counter (OTC) market has wider spreads and makes it tough to get as much value for the products, often times pennies on the dollar.
Addressing the challenges investors face when an ETN goes south, Credit Suisse extended an olive branch by offering early redemptions that allowed investors the opportunity to exit their positions before the products were delisted. Credit Suisse also reduced the size of redemption blocks of DWTI and UWTI from 25,000 ETNs to 500 ETNs,3 making it easier for investors to redeem directly from the issuer.
Still, the products’ delisting illustrates some of the risks involved when investing in ETNs. Delisting an ETN is complicated, as it requires unravelling derivatives contracts, and can leave investors with much less in hand than ETFs because of the fact that the ETN has no underlying securities. And when these products are forced over to the illiquid OTC environment, spreads can start to widen.
While ETNs may offer certain advantages that ETFs do not, they may also carry less understood risks. At the end of the day, it is important that investors do their homework before committing to products like ETNs and other derivatives.