ETNs were constructed to meet investor needs and have several advantages to consider:
Taxes
Because ETNs don't hold any portfolio securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN. ETN shares reflect the total return of the underlying index; the value of the dividends is incorporated into the index's return but is not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs which regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. The short-term capital gains rate is equivalent to an individual's ordinary income tax rate.
When the investor sells the ETN, the investor is subject to a long-term capital gains tax. The taxable event occurs only when the investor sells the ETN. With conventional ETFs, a long-term holder would be subject to capital gains tax each year. The ability to significantly boost returns by escaping annual taxes on dividends is a huge benefit to ETNs. However, this tax treatment does not apply to currency ETNs.
Tracking error reduced
Theoretically, an ETF should give you the exact return of the index it tracks, minus the expense ratio. But sometimes the difference between the ETF and its index is larger than the expense ratio. This extra difference between the portfolio's return and the value of the index is called the tracking error.
Tracking error can be a significant issue for ETFs that are unable to hold all the components of a benchmark index, either because there are too many components and/or the components are illiquid. As a result, the value of the ETF and the value of the benchmark index may diverge. In contrast, the ETN issuer promises to pay the full value of the index, no matter what, minus the expense ratio, completely eliminating tracking error.
It should be noted that ETNs do have an underlying foundation. Typically, they are constructed of futures, options, stock swaps, and other instruments to approximate the benchmark index return. However, the underlying foundation is irrelevant to the investor; if the bank's strategy fails to match the index, the bank is on the hook for paying off the rest of the gains to the investor.
Market access
ETNs bring the financial engineering technology of investment banks to the retail investor, providing access to markets and complex strategies that conventional retail investment products cannot achieve. For example, Barclays Bank in 2011 issued ETNs that allowed investors to profit from increases in stock market volatility and another ETN that allowed investors to profit from changes in the shape of the US Treasury yield curve.
In next blogpost, we will discuss disadvantages of ETNs.