An important lesson: ETFs vs. ETNs

Byron S. Sass, BridgeTower Media Newswires

Exchange traded products such as exchange trade funds (ETFs) and exchange trade notes (ETNs) have soared in popularity among a wide variety of investors over the past decade. Their popularity has resulted in a record level of money being invested into both types of investments. For example, in 2002 there was approximately $87 billion invested in ETFs; as of the end of May , according to the Investment Company Institute, there was approximately $2.9 trillion invested in ETFs.

Despite the growth of the ETF industry, many questions, misunderstandings and fears remain with respect to exchange traded products. One of the biggest assumptions among most investors is that ETFs and ETNs are essentially the same product. To debunk this myth, let’s examine both products and show how different they really are.

First, an ETF investment fund is traded on a stock exchange throughout the day. Each share of an ETF is backed by a percentage of a basket of securities (e.g., stocks, bonds, commodities). Each fund’s particular basket of securities is determined by the objective of the ETF. For example, if the objective of the ETF is to track the S&P 500, the basket of securities would be made up of the stocks that comprise the S&P 500 index. At the end of the day the value of the fund is calculated to determine the value of each share, just like a mutual fund. The obvious advantage over a mutual fund with a similar objective would be intra-day liquidity, which affords investors the ability to buy or sell as the respective securities that comprise a fund fluctuate throughout the day.
In contrast, an exchange trade note is a senior, unsecured, unsubordinated debt security issued by an underwriting bank that is traded on a stock exchange. An issuer of an ETN promises to pay the performance of the index from the inception date of the ETN to its maturity with investor fees removed. Unlike an ETF, the ETN is backed solely by the credit of the issuer. Further, instead of the assets backing an ETF, an ETN is backed solely by a promise from issuer to return the performance of the objective of the fund out of their own pocket.

Based on these two definitions, it is apparent that ETFs and ETNs are not the same. By comparing the two, we see that ETNs carry more risk compared to ETFs with the primary differentiator being counterparty risk. In the event something bad happened to the company running the ETF, the money in the ETF is safe and is backed by actual securities. Thus, one can define the value of the ETF off of the value of those securities. On the other hand, in the case of an ETN, if the issuer responsible for the ETN becomes impaired an ETN investor could lose their total investment because the ETN is backed by a promise, not an asset.

Another issue with ETNs is that price disconnects can occur between the market price and underlying net asset value when the sponsoring company no longer issues shares of the ETN. This can occur when the fund becomes too big for the sponsoring company to hedge out its risk exposure. An example of this is the natural gas ETN, GAZ, which stopped issuing shares during 2012 and quickly saw the market price move to a premium, peaking at 184%. Since ETFs are normally created through in-kind creation, this issue would not be applicable to ETFs. ETFs have had their fair share of issues as well—including the flash crash of 2010 and the price disconnect on the market open on Aug. 24, 2015. Those problems resulted mostly due to trading mechanics, market halts and stop-loss orders.

When investing in any investment product, it is important to have a thorough understanding of the mechanics and how it is set up. When looking at an ETF or an ETN, the question to ask yourself is therefore whether you want your investments to be backed by assets or a promise to be repaid. In my opinion, the potential pitfalls associated with ETNs do not outweigh the potential benefits. For investors who are looking to use exchange trade products to index, minimize risk and diversify their portfolio, I believe ETFs provide a more attractive solution than ETNs.

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Byron S. Sass is a Fixed Income Analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, non-profits and trustees.  Offices are located at 183 Sully’s Trail, Pittsford, NY 14534, (585) 586-4680.

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