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Author: sportscliche One star, 50 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2167  
Subject: Re: ETF vs ETN: tax efficiency Date: 11/16/2011 10:04 PM
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I've done some more research and corresponded with a few experts on this question. I believe I now have a basic understanding of how the index ETNs work and will summarize here for those interested. I haven't found all this information in one place, just piecing things together in what appears to be a somewhat murky and mysterious business. I fully admit that I could be off the mark here and welcome any criticisms and corrections.

The key for the ETN issuer is to setup a couple of highly leveraged derivatives on the index. It seems the investment banks can get as much as 10 times leverage on their hedges, possibly more.

Let's assume they have access to 10x leverage. Also assume they will owe 15% capital gains tax on any profit realized by their hedges. The ETN issuer will place 11.76% of the note purchaser's capital into the hedge. This will insure against appreciation of the index and cover the capital gains tax (if there was no tax, they would only need 10% to hedge in this example). They still have 88.24% of the customer's capital at their disposal.

If the index drops by more than 11.76% the note issuer will make a profit because even though the upside hedge goes to zero, their note obligation is less than the cash left over after hedging.

If the index drops less than 11.76%, the hedge is again worthless but the issuer will not have enough cash on hand to redeem the note at fair value. That means they'd have to have a hedge on the hedge. I'm not entirely sure about the details, but there are buy-write hedging strategies to make money in sideways markets. Using 10x leverage on the second hedge represents in the neighborhood of 1% of the note value. This could get covered by a combination of the fixed tracking fees charged to the note holder plus income generated by investing the cash balance in rated corporate bonds or preferreds, for example.

The ETN issuer is then in a position to make money no matter what happens with the index: up, down, or sideways. None of their own money would be at stake. It is essential for them to have leverage (the more the better) on their derivatives as well as tracking fees. In contrast to an ETF, the fees are there to pay for hedging costs.
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