ETN’s or Exchange Traded Notes are investment vehicles that trade on exchanges just like other stocks or ETF’s (exchange traded funds). However, they are loans made to banks on unsecured debt securities and not backed by any specific asset. Initially, investors loan banks money, the bank turns around and invests those funds with certain investment objectives. The strategy of each fund varies, but most try to match the results of other underlining assets. Certain ETN’s aim to execute their own unique strategies to bolster investor returns.
Unlike ETF’s though, there are no assets that directly back ETN’s. ETN’s are more like Bonds, they are issued for fixed period of time, then they mature. I have typically seen a 30 year maturity on each ETN. Unlike bonds though, there is no interest paid. However, some notes (like the ones I invest in) pay coupon payments, it helps to think of these like dividends, but dividends imply ownership in the underlining security. ETN’s do not have ownership rights.
Risks for ETN’s
Liquidity: Since ETN’s are not a popular main street investment, some have very low volumes making them difficult to trade. The issuing bank of the ETN investment can chose to shut them down at any time causing all exchange trading to stop. Typically, there are clauses established by the bank up front explaining what can trigger these events. For example, the note can specify a floor Net Asset Value (NAV) threshold. If the note falls below this value, it can trigger early redemption or suspension of trading. This results in a suddenly ill-liquid investment making them difficult to redeem. The issuer could also choose to redeem the notes early and pay out at the current net asset value. The difference of value vs. price paid at redemption will result in a gain or loss of principal.
Bank Risk: The underlining bank or entity that backs the security could in theory go under. The two banks that back the ETN’s that I trade are UBS and Credit Suisse. They have been around 157 and 163 years respectively. Values of the ETN’s could go down if the bank’s credit rating goes down. The issuing bank can also shut down the notes and move investors into new series B funds as is happening right now with UBS. This is impacting two of my holdings, CEFL & BDCL.
Fees: Like most investments, there are fees involved with ETN’s. Fees are taken out of any investment earnings before they pay the coupon payments to holders of the notes. If the underlining investments do not produce, fees could eat into the net asset value. The NAV should be similar to the price of the traded notes.
Options & Leverage: The banks may use options or trade with leverage to achieve performance. This inherently increases the risk of performance. Options are short term bets on the price movement and if wrong, could result in significant losses. Leverage enhances both wins and losses.
Benefits
Potential Tax benefits: Some claim there are tax benefits for ETN’s, however this is a broad statement that does not apply to all different types. Since there are no underlining assets owned, they cannot distribute capital gains. There are some ETN’s, like the ones I own, that do pay regular coupon payments. These are taxed like dividends.
No Tracking Errors: Unlike ETF’s, ETN’s can provide an exact tracking to the index they aim to track. Since there is no direct ownership in the assets making up the index, there are no tracking errors to the index. ETN’s use other means to produce the same results of the tracked index.
Leveraged Returns: See the next section below regarding my portfolio for this major benefit.
My Portfolio
I have found a subset of ETN’s that are 2x leveraged that make monthly, bi-monthly or quarterly coupon payments. This is the bulk of my portfolio. All but three of my ETN’s are 2x leveraged which means the yields are higher than the indexes they track. They are also much more volatile. My core strategy is long term buy and hold seeking the cash flow these assets produce. My group of 10 ETN’s are yielding between 7.5% & 19% right now. While 7 of my ETN’s are 2x leveraged and pay coupons, I have diversified into some commodities to hedge myself to some degree.
I fully acknowledge that my portfolio of holdings are speculative and have many risks that is not for the novice investor. Having a clearly defined strategy and staying with it has been a key pillar to my success so far. In future blog posts, I will go into more of my strategy as I share my portfolio over time. I have seen the market drop a few times in the last year causing my portfolio to drop by 11+% within a 2 week period. This is to be expected along with the major gains.
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