All About Buying Exchange Trade Notes

By Dallin Alexander

Exchange Traded Notes are the latest financial product to hit the street, and they are quite different from Exchanges Traded Funds. They may have a similar name, but ETNs are more risky than ETFs.

An unsecured promissory obligation issued by a company is a bond, and you buy a bond making a bet that the company will pay the interest that it promises during the life of the bond. Exchange Traded Notes are unsecured promissory obligations that are issued by financial institutions, and rather than offering a fixed rate of interest they are offering you a return that is linked to an index. In return for taking on the credit risk you track an index with zero tracking error.

ETNs can track absolutely any index at all so they offer a far greater diversity than ETFS. Exchange Traded Notes have a fixed maturity date, and they can also be traded throughout the day just like Exchange Traded Funds.

Although ETNs do not have a tracking error they still trade at premiums and discounts to their indicative Net Asset Value (NAV). Where there is a steep discount you can take this as an indication that the market is concerned about the company's credit worthiness. However, with that said it is worth noting that the Lehman ETNs tracked their index with barely any discount right up to default.

The unique structure of the ETN allows providers to replicate a wide range of asset-allocation strategies across commodities, foreign markets, and currencies. This means that individual investors can enjoy the benefits of accessing markets that before the advent of ETNs were only open to rich clients.

In terms of regulation you should note that ETFs are subject to the Investment Company Act of 1940, whereas ETNs fall under the Securities Act of 1933. There are two main differences that result from this, one is that the ETN can offer access to more exotic assets, and the second is that an investor in an ETN does not have any claim to the assets that constitute the index, whereas the investor in the ETF does.

Holding ETNs for more means that any profit will be treated as long term capital gains, but if you sell them in under a year then any gains will be taxed as ordinary income. - 31382

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