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A Comprehensive Guide to Exchange Traded Notes

05 Oct 2023

Introduction:

Exchange-traded notes (ETNs) are often mistaken for Exchange-Traded Funds (ETFs). However, ETNs are distinct investment entities. While the confusion between the two is common, it is imperative to differentiate them. To use ETNs effectively in your portfolio, earn the best returns and achieve diversification, it is crucial to understand how they work. Here is a comprehensive guide on ETNs that can help you make prudent investing decisions. 

What are ETNs?

ETNs combine the elements of bonds and ETFs. ETNs are a specific category of bonds that function as debt instruments. They are issued by financial institutions like banks. However, unlike traditional bonds, ETNs do not provide regular interest payments. Instead, they are designed to track the performance of an index. Instead of receiving interest, you gain returns based on the performance of the specific index the ETN tracks. These returns can either be positive or negative, depending on the performance of the underlying index. 

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ETNs have a fixed maturity period, typically 10 to 30 years. Like bonds, they can be redeemed at their face value upon maturity. The maturity amount includes the principal investment amount and any return you earn on your investment. You can trade ETNs on recognized stock exchanges such as the Bombay Stock Exchange (BSE) or the National Stock Exchange (NSE). ETNs can be bought and sold similarly to stocks and have high liquidity and flexibility.

Features of ETNs

Here are some features of ETNs that can help you understand them better:

  • No ownership of assets: ETNs do not possess any tangible assets. They only track the performance of underlying assets such as indices, commodities, or other financial instruments. This means you do not own a stake in these assets but gain from their price movements.
  • High liquidity: ETNs are traded on stock exchanges just like stocks. You can purchase or sell them during regular trading hours at prevailing market prices. This flexibility offers you high liquidity. It also allows you to adjust your portfolio as per market dynamics and cater to your financial needs.
  • Expense ratio: Similar to other investment products, ETNs come with an expense ratio to cover the cost of management, administration, and other expenses. This ratio can impact the overall returns from your investment.
  • Issuer credibility: When investing in ETNs, you essentially trust the issuer to provide you with optimal returns based on the performance of the underlying index. ETNs rely solely on the issuer's credibility. Therefore, it is imperative to carefully evaluate the reputation and reliability of the issuer before investing in ETNs to mitigate issuer default risk. 

Why invest in ETNs?

Investing in ETNs can offer several advantages, making them an attractive option. Here are some reasons to invest in them: 

  • Offer tax diversification: ETNs offer tax diversification benefits by deferring taxes until maturity. Since you do not receive regular dividends or interest payments, you do not need to pay Short-Term Capital Gains (STCG) taxes, typically higher than Long-Term Capital Gains (LTCG) taxes. You only pay LTCG upon receiving the lump sum amount at maturity. 
  • Ideal for passive investing: ETNs are tailored for passive investors. They mimic the performance of the underlying index they track, offering you a hands-off approach to investing.
  • Access to diverse markets: ETNs offer exposure to markets that might otherwise be inaccessible to you. Markets such as commodity futures, currencies, and foreign markets can be readily accessible through ETNs. They can be a simple way to diversify your portfolio if you seek market exposure across various asset classes and geographical regions. 

Risks involved in ETN

While ETNs offer potential benefits, it is crucial to know the associated risks. If the issuer of the ETN fails to meet its financial obligations, you will likely face substantial risks. In the event of issuer insolvency, you stand to incur potential losses on your investment. 

To sum it up

ETNs can be a strategic investment choice. They offer a tax-efficient solution and cater to various investment needs. ETNs allow you to diversify your portfolio effectively and tap into previously inaccessible markets. However, understanding the risk involved with ETNs is crucial before considering ETNs as a part of your portfolio. You must thoroughly research and evaluate the creditworthiness and reputation of the issuer. Due diligence can help you mitigate the risks associated with issuer default and follow a more secure investment path.  

 

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