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ETFs 112: What to Know about Exchange-Traded Notes

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1.
A big premium on an exchange-traded note is a good sign.
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False. A big premium usually indicates that the market is uncomfortable about the health of the issuing company.
2.
Exchange-traded notes (ETNs) and exchange-traded funds (ETFs) have a lot in common. Which one of the following statements is false?
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ETNs and ETFs both hold a basket of securities in order to track the performance of an index. ETNs and ETFs both trade on exchanges; that's what the 'E' in their name stands for. They both have a create and redeem process for their shares, which allows authorized participants to exchange shares for the net asset value of the underlying index, preventing large trading spreads from opening up. They both charge a fee based on a percentage of the assets under management. However, only ETFs are funds which actually hold securities in trust for the shareholders; ETNs are the debt of the issuer, who promises to pay the return of the underlying index instead of a set interest rate.
3.
A large premium on an existing exchange-traded note might do what if new shares of the note are issued?
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Fall. Large premiums can quickly collapse upon the issuance of new shares of an exchange-traded note.
4.
Investors can protect themselves from the credit risk of owning an exchange-traded note by using stop-loss orders.
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False. Using a stop-loss order would address market risk, not credit risk. To address credit risk, investors should monitor the financial situation of the issuing bank.
5.
What is the main tax advantage of exchange-traded notes over exchange-traded funds?
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Taxes are charged only on capital gains when the ETN is sold. ETNs are not tax-free, but they can be used to defer taxes as typically dividend or interest income is applied as an increase in the principal, so investors only have to pay taxes upon sale. At that time, the typically lower capital gains rate will be applied, not the ordinary income rate, and if the ETN was held for longer than a year, the lower long-term rate will be applied. The exception is with currency ETNs, which are taxed like other currency investments including ETFs.