In the past decade, exchange traded products such as Exchange Traded Funds, or ETFs, and Exchange Trade Notes, or ETNs, have vaulted in popularity among retail and institutional investors. This trend resulted in a record level of money being invested into exchange traded securities.
For example, in 2002 there was $102 billion in ETFs (Investment Company Institute, Investment Company Total Net Assets by Type 2012 Investment Company Fact Book) and at the end of third quarter of this year there is $1.28 trillion in ETFs (Investment Company Institute, Assets of Exchange-Traded Funds by Type Exhange-Traded Fund Data, September 2012).
Yet, with the growth of the ETF industry, there are still a lot of questions, misunderstandings and fears surrounding exchange traded products. One of the biggest assumptions among most investors is that ETFs and ETNs are essentially the same and possess similar risk characteristics. To deconstruct this myth we need to understand the structures of an ETF and an ETN and how they are different.
An ETF is an investment fund traded on a stock exchange throughout the day. Each share of an ETF is backed by a percentage of a basket of securities (stocks, bonds, commodities). This 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 Index, the basket of securities would be made up of the stocks in 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.
An Exchange Trade Note is a senior, unsecured, unsubordinated debt security issued by an underwriting bank that is traded on a stock exchange. The issuer of the ETN promises to pay the performance of the index from the inception date of the ETN to its maturity with the investor fees removed.
Unlike an ETF, the ETN is backed solely by the credit of the issuer. Essentially, instead of the assets backing an ETF, an ETN is backed solely by a promise from the 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. The main risk is counterparty credit risk.
In the event something bad happened to the company running the ETF, the assets in the ETF are backed by actual securities. Using the value of these securities one can define the value of the ETF. In the event of an ETN, if the issuer responsible for the ETN goes bankrupt, you could lose your total investment because your ETN is backed by a promise, not an asset.
For investors who are looking to use exchange trade products to index, one can minimize risk and diversify their assets by utilizing ETFs. The potential pitfalls associated with ETNs do not outweigh the potential payouts. The question to ask yourself when deciding to invest in either an ETF or an ETN is do you want your investments to be backed by actual assets or an IOU?
*ETFs can use different methods to track their investment objective. Two ETFs could state they track the performance of gold and use different methods. One could actually hold gold to represent the shares’ value and another could use derivatives. The fund that uses derivatives has more risk and higher trading expense. It is important to always read the prospectus and understand how the ETF is achieving its performance and the potential risk involved when investing.
Byron S. Sass is a fixed income analyst account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.