What are Exchange Traded Notes or ETN?

Finance Feb 03, 2021

Exchange traded notes are not to be confused with the similarly named exchange traded funds. ETNs are more akin to bonds. However, ETNs are traded on major exchanges alongside ETFs and stocks.

I recently bought an ETN, and was greeted with a warning about it being a complex financial instrument that bears more risk than normal securities. That's because exchange traded notes carry a small risk of default, since they are actually unsecured debt. If the underwriter (usually a bank) were to go bankrupt, my investment would be lost.

In honesty though, for small time investors like myself choosing large, relatively dependable institutions? This risk is negligible.

Exchange traded notes offer a promise to match the performance of an underlying asset or index, for instance matching the S&P 500. Rather than owning the stocks that make up the S&P 500, an ETN promises to merely match the index's return at its maturity date.

One of the cool things about ETNs is that they tend to be tax-efficient by not distributing dividends or capital gains. Thus you're only taxed when you sell the ETN, meaning you can wait until it's a long-term capital gain.

You can also get some really interesting ETNs like VXX, which tracks volatility.

VXX is a dangerous chimeric creature; it’s structured like a bond, trades like a stock, follows VIX futures and decays like an option.  Handle with care.
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In fact, there's a lot of ETNs that employ fascinating strategies out there, such as covered call ETNs. However I would stay away from these complex financial instruments under one of the best investing truisms to learn: "Never invest in something you do not understand how it makes money."

To recap, exchange traded notes come in a wide variety of complexities and strategies. However, the traditional ones are incredibly similar to bonds, which makes them valuable in times of economic uncertainty.

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