These emerging financial instruments have created new opportunities to invest in commodities, currencies, and stocks

ETN Basics

For U.S. investors, Barclays Global Investors offers a series of exchange-traded notes (ETNs) that operate under the name “iPath”. These notes are classified as senior unsecured debt backed by the credit of Barclays Bank and do not contain any voting rights. The iPath notes come with 30-year maturities and they track commodity, currency and stock market indexes.

ETNs are not registered or organized as mutual funds or ETFs, but are debt instruments. They pay a return linked to the performance of a market index.

Familiar Features

Comparing ETFs and ETNs will reveal many similarities. For example, both ETFs and ETNs track leading and recognizable market indexes. Also, ETNs are bought and sold with a traditional brokerage account just like ETFs.

Another important characteristic of ETNs is they have an arbitrage feature that’s designed to keep market prices closely hinged to the intrinsic value of the benchmarks they track. Investors that accumulate large blocks of notes (usually 50,000 or more) can redeem them back to the issuing financial institution on a weekly basis in order to take advantage of any pricing discrepancies that may exist. The redemption feature of ETNs is intended to reduce the possibility of notes trading at steep premiums or discounts.

Liquidity Options

Investors that opt to keep their ETN to maturity receive a cash payment calculated from the beginning trade date to the ending period, or maturity date. Applicable fees are deducted and can reduce the value of the payment. Maturity periods can vary and may be as long as 30 years. ETN investors are not required to hold their note to maturity. Prior to maturity, ETNs can be sold on the exchange where they trade or they can be redeemed in large blocks.

ETNs and Taxes

Under the current tax law, ETNs are treated and taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption, or maturity of their note. If held to maturity, the future payment of the contract is dependent on the value of the underlying benchmark index.

ETNs are very tax efficient and note holders can control the timing of a taxable event. Unlike traditional mutual funds or ETFs which can have periodic tax gain distributions, ETNs aren’t required to make taxable distributions.

Calculating the Indicative Value of an ETN

As debt securities, ETNs do not trade at or have a net asset value (NAV). Their daily indicative value is based upon the index level which is published daily by an index provider or media outlet. The purpose of calculating the indicative value of an ETN is to approximate the intraday economic value of the note. (See the equation below.)

Indicative Value = Principal Amount per Unit x Current Index Level/Initial Index Level minus Current Investor Fee