Weighing the Risks: Are Exchange- Traded Notes Right for Your Clients?

Smith, Jeffrey; Small, Kenneth
October 2010
Journal of Financial Planning;Oct2010, Vol. 23 Issue 10, p56
Academic Journal
This paper introduces readers to the exchange-traded note (ETN) structure. It provides a discussion of the differences between the ETN and exchange-traded fund (ETF) structures. The authors examine ETN credit risk in light of their underlying structure. They show that credit risk is a declining function of redemption frequency and that credit risk is a declining component of the total risk when redemption opportunities increase. If credit risk can be accurately estimated, investors can mitigate credit risk by purchasing ETNs with frequent redemption opportunities. However, given the bankruptcy of Lehman Brothers and the demise of the Opta ETNs, investors should remain cautious, but realistic, when evaluating the credit risk of ETN issuers. The authors also examine the capital gains treatment differentials between ETEs and ETNs assuming identical underlying indexes. The authors identify a slight tax advantage to holding ETNs. This tax advantage is directly related to the turnover of the underlying index. The ETN structure is favored when turnover in the underlying index is high. ETNs offer a tax-preferred way to provide clients exposure to unique trading strategies, as long as the financial planner follows the guidelines, which involve ETNs with frequent redemption opportunities when issued by highly rated investment firms.


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