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What is an ETN? A Beginners Guide to Exchange Traded Notes

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What is an ETN? Everything You Need to Know About Exchange Traded Notes

Savvy investors in today’s marketplace should be familiar with ETNs. The acronym ETN stands for exchange traded note. This investment tool shares many similarities with an ETF, which is an exchange traded fund. However, there are a few key differences between the two. And depending on the type of investment you’re trying to make, these differences could produce largely differing results. This guide will give you everything you need to know about ETNs. Additionally, it will also fill you in on how an exchange traded note functions in the world of cryptocurrency.

What is an ETN? The Basics

An exchange-traded note is a debt security. As such, it is issued and backed by an underwriting bank. ETNs are structured to track a particular index, and they pay out according to set market benchmarks.

ETNs first emerged around 2002. That year, the Equity Structured Products Group at Morgan Stanley began selling a product called BOXES. This first ETN product was designed to make it easier to access the biotechnology index.

The concept further evolved in the following years. In particular, Barclays began selling a similar product in 2006. Barclays began calling it an exchange-traded note, and the name stuck.

Since then, a number of banks began selling ETNs. Today, there are somewhere around 140 ETNs being traded in the U.S. Combined, there are now ETNs that track most indexes, including fields like commodities, currencies, emerging markets, and many others.

In fact, one of the things about ETNs that attracts investors is that they make it relatively easy to invest in otherwise niche or difficult to access market sectors.

Additionally, ETNs are purchased and sold on regular stock exchanges. This makes them extremely accessible to a wide range of investors.

ETN vs. ETF: What are the Differences?

There are many key similarities between an exchange traded note and an exchange traded fund. For starters, they both track a specific index. Similarly, both ETNs and ETFs are traded on stock exchanges and can be purchased directly through your regular stockbroker.

At the same time, there are a few important differences between these investment tools. One of the biggest has to do with what lies at the foundation of each structure. An exchange traded fund holds a stake in actual assets. This means that investors in an ETF are tangentially investing in a particular index but without personally owning any shares in the underlying commodity.

ETNs are very different. Specifically, there are no actual assets involved in an ETN. Instead, investors in ETNs are buying into a debt security. That security tracks an index, but at no point does the note ever become an asset-owning fund.

This is the fundamental difference between the two. And it produces very different outcomes. For example, if you buy into an ETF you can receive returns based on the value and performance of the underlying assets. But when you buy into an ETN you do not receive any regular or ongoing returns. Rather, you get paid out when you sell your note.

It also means that the risks are different. When you invest in an ETF, your risk is tied to the real-world performance of the assets. But in general, when you buy into an ETN your risk is tied to the overall index as well as the credit of the underwriting bank. Simply put, if the bank fails so does the note.

Exchange Traded Note: Benefits and Risks

What is an ETN? Everything You Need to Know About Exchange Traded Notes

Now that you’re a bit more familiar with what ETNs are, let’s take a look at some of the advantages and disadvantages of this type of investment. As summarized by investment experts at Fidelity, the main benefits of an exchange traded note include:

  • Better tax structure. When you buy into an ETF you may have to pay taxes any time you receive interest or dividends. This could mean regular, ongoing capital gains taxes. But when you invest in an exchange traded note, you don’t pay ongoing taxes. Instead, you pay capital gains tax only when you sell your note.
  • Less room for error. Sometimes, ETFs can see tracking errors that lead to gaps between the real-world value of the index being tracked and the ETF. But that’s not the case with an ETN. Instead, the bank issuing the ETN is obligated “to pay the full value of the index, no matter what, minus the expense ratio” and management fees.
  • Improved access to complex investments. ETNs make it much easier for retail investors to tap into indexes that might otherwise be difficult to access.

The risk is the primary disadvantage of investing in an exchange traded note. As outlined above, when you buy into an ETF you have one main source of risk: the real-world performance of the underlying asset.

But when you invest in an ETN you have two sources of risk. You still have to watch the real-world performance of the index being tracked by the note. Additionally, there is also risk linked to the bank underwriting the note.

This second type of risk became very real during the 2008 financial crisis. As big banks like Lehman Brothers and Bear Stearns collapsed, they were left unable to pay any ETNs they had underwritten.

ETNs and Cryptocurrency

So far, the prospects of a cryptocurrency ETF remains unclear—at least in the U.S. So far, the SEC is too suspicious of crypto’s security and long-term viability. As a result, the agency has so far denied proposed crypto ETFs.

But the picture could be a little bit different when it comes to cryptocurrency ETNs. For example, investors can now buy into a product called Bitcoin Tracker One.

This is an exchange traded note tied to the performance of Bitcoin. And while it’s listed and regulated in Sweden, American investors can access the note. It is currently quoted in U.S. dollars under the ticker CXBTF on the NASDAQ Stockholm exchange.

This is a potentially good way to invest in cryptocurrency without having to buy, hold, and sell actual coins and tokens. Similarly, it mitigates the need to manage cryptocurrency wallets. Further, it could function as a kind of segue to crypto ETFs.

In fact, Bloomberg called this crypto ETN “a soft opening of sorts for a crypto ETF.” One way or another, if you’re interested in entering the crypto game, this or a future crypto ETN could be an excellent way to dive in.