ETNs are essentially unsecured promissory obligations issued with the backing of a financial institution. These "notes," which can be thought of as bond issuances, guarantee investors the return on a given index and have stated maturity dates (though, like stocks, they can be bought and sold throughout the day in the interim for those who don't plan to hold to maturity). Thus, ETNs carry the credit risk associated with the backing financial institution but will not produce any index-tracking error.
Despite the lack of tracking error that ETNs enjoy, we think it is a good practice to monitor whether the market price of a given ETN trades at a discount to its indicative NAV. This would be a "red flag" indication of the market's nervousness related to the issuer's creditworthiness. In the end, to fully grasp the extent of the credit risk associated with a given ETN, investors should lean on a stronger fundamental analysis of the bank, rather than potential discounts in the market price versus the NAV.
Understanding the tax consequences of any investment should be at the forefront of the investment-selection process for all individual investors. Because ETNs are a type of debt instrument, they often have extremely lengthy prospectuses that detail the tax consequences as well as the unique creation and redemption process that ETNs employ.
Here is a summary of taxation rules regarding ETNs (other than currency-tracking funds):
1) It holds no real assets; it's a promissory note.
2) You will be taxed only upon sale.
3) Short-term capital gains apply when held less than one year.
4) Long-term capital gains rates apply when held more than a year.
5) There are typically no dividends or interest income.
The IRS has ruled that currency ETNs should receive the same tax treatment as other vehicles that offer exposure to single currencies. That's in contrast to Barclay's assertion that shareholders should be taxed only when they sell their ETN shares.
The ruling applies only to currency ETNs. However, the IRS has asked for comments on how other ETNs should be taxed. Hopefully, the IRS will issue a ruling soon to provide investors much-needed clarity on this issue. In the meantime, investors are left to speculate about how these vehicles may be taxed in the future. If the IRS decides to treat ETNs like other competing vehicles, ETNs will lose a major point in their favor.
The fact remains that ETNs are really the most effective (and only) vehicles for investors seeking exposure to assets like foreign currencies or asset-allocation strategies (as specialty satellite holdings, of course). However, for risk averse investors who are unwilling to assume the credit risk and potential loss of their investment--regardless of how low the probability of default may be--we think avoiding the structure altogether could be a prudent and sensible choice.