Exchange-Traded Notes: The Facts and the Risks

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 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 type of debt instrument 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.

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

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 that 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.

ETNs rely on the creditworthiness 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. As a result, it's important for investors to regularly monitor the financial health of ETN issuers and consider diversifying among multiple issuers to help mitigate potential losses.

The trading activity of ETNs varies widely. For ETNs with very low trading activity, bid-ask spreads can be exceptionally wide. Plus, many ETNs are designed to mimic the returns of a specialized index. These indexes may be concentrated in a single asset (for example, gold) or include just a handful of stocks. If the referenced index experiences volatility or significant declines, the ETN's price will reflect those movements, potentially resulting in substantial losses for investors.

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 when ETNs have become too large or too expensive to hedge. 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, a calculated figure that represents the value of the ETN based on the performance of its underlying index or benchmark, minus any applicable fees. 

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 noteholder-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 an ETN issuer's health or to delve into the business considerations that issuers weigh when deciding whether to launch or continue supporting an ETN. Plus, some ETNs regularly trade with wide bid-ask spreads. What's more, if an issuer decides to delist an ETN, investors may have few options other than to trade the product in the OTC market (where spreads are usually wider than on national exchanges) or wait for the ETN to mature. 

As a result, investors may find ETNs to be more trouble than they are worth. Before considering any specific ETN, investors should read the ETN's registration statement filed with the Securities and Exchange Commission (SEC), the pricing supplement, and consult the ETN's prospectus to understand the term of the note (the length of time before the note matures) as well as its strategy, risks, fees, and expenses. We also recommend that prospective investors seek advice from a qualified expert before purchasing an ETN, especially when the prospective investor doesn't have prior experience investing in this type of ETP. 

If you still think an ETN might make sense for your portfolio, we encourage you to first check out an article published on October 20, 2022, by The Financial Industry Regulatory Authority (FINRA) that describes the features and risks associated with ETNs: "Exchange-Traded Notes—Avoid Unpleasant Surprises." And, as always, ensure you fully understand the structure and risks of any investment before adding it to your portfolio.