Exchange-Traded Notes (ETNs)

Exchange-Traded Notes (“ETNs”) are unsecured debt obligations issued by a bank or other financial institution. Exchange-Traded Notes do not have ownership in an underlying portfolio of assets and instead track a market or other benchmark index. At maturity, the ETN promises to pay a return of the index it tracks, less a management fee. The return for the investor is dependent on the performance of this benchmark index.

Repayment of principal and any additional return at maturity or repurchase by the issuer also depends on the issuer's ability to pay. If an issuer declares bankruptcy, ETN investors could lose their entire investment.

As its name suggests, ETNs trade on major securities exchanges. The market value of ETNs generally moves in the direction of the particular index or benchmark that it tracks. Thus, an investor is exposed to both the issuer’s creditworthiness and the risk of the particular index or benchmark that the ETN is tracking.

According to FINRA’s Regulatory Notice 19-21, ETNs have materially different risk profiles than other debt securities. Because of some of their features, ETNs may not be suitable for all investors.

Key Characteristics of ETNs

Unlike exchange-traded funds (“ETFs”), ETNs do not have ownership in an underlying portfolio of assets. Instead, ETNs track a market or other benchmark index.

ETNs offer retail investors access to niche product areas such as emerging markets, commodities, currencies, and other specific strategies. Exchange-Traded Notes can also give investors the ability to profit from increases in stock market volatility or changes in the shape of the US Treasury yield curve. In fact, the financial engineering underlying ETNs is comparable to that used by investment banks to create structured products for institutional clients.

Typically, ETNs are made up of stock swaps, futures contracts, options, and other instruments to approximate the benchmark index return. ETNs are risky, complex, and offer no principal protection to investors. They are generally not recommended for conservative, elderly, or long-term investors.

Knock-Out Features

Exchange-Traded Notes may have “knock-out” features or give issuers early redemption rights. These features can force an investor to cash out of the investment and cause the ETN’s returns to diverge from the returns on an ETF investment tracking the same index.

Income Distributions v. Tax Advantages

Exchange-Traded Notes do not make regular income distributions; they do not distribute dividends or make interest payments to investors while they own the ETN. Due to their structure, ETN investors avoid short-term capital gains taxes but are still subject to a long-term capital gains tax when the investor sells the ETN. This tax treatment does not apply to currency ETNs tracking an underlying currency exchange rate.


Exchange-Traded Notes are less liquid than ETFs and may also contain holding-period risk. An ETN’s performance over long periods can differ from the underlying index’s performance.

Tracking Error

The tracking error is the difference between a portfolio’s return and the index’s value. An ETN issuer promises to pay the index’s full value, minus the expense ratio, which eliminates tracking error. However, suppose the issuer’s strategy fails to match the index.  In that case, the issuer will still be responsible for paying off the rest of the gains to the investor.

Margin Requirements for Exchange-Traded Notes

FINRA Rule 4210(e)(2)(C) provides exceptions for margin requirements involving certain products. Reduced margin requirements are available to ordinary investment-grade debt securities, non-equity securities, and “other margin eligible non-equity securities.”

Because of their complexity and materially different risk profile, FINRA has increased margin requirements for ETNs. FINRA pointed to the significance of the reference index or benchmark risk to an ETN position in explaining its reasoning.

Leveraged or Inverse Volatility-linked ETNs

FINRA has also cautioned investors to fully understand volatility-related ETN products before investing in them.

Leveraged or inverse volatility-linked ETNs carry what is known as daily reset risk. In other words, they “reset” every day. This means that they are only designed to accomplish the ETN’s stated leveraged or inverse objective on a daily basis. This feature can make ETNs risky medium or long-term investments. Further, volatility-linked ETNs have no underlying portfolio. They are unsecured debt obligations. The financial institution backing the product does not have to necessarily be invested in any assets tied to the index.

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