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Understanding the Difference Between ETNs and ETFs

Although both vehicles offer low cost access to unusual asset classes, ETNs can often court some risks not seen in traditional mutual funds

Morningstar ETF Analysts 11 November, 2010 | 10:42AM
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The term 'Exchange Traded Product' (ETP) is a broad umbrella which covers a number of different investments including ETFs (Exchange Traded Funds), ETCs (Exchange Traded Commodities or Currencies) and ETNs (Exchange Traded Notes). While the 'C' in ETC is self-explanatory, the difference between 'Funds' and 'Notes' is less obvious, especially considering they can sometimes track the same index. Although both vehicles offer low cost access to unusual asset classes, ETNs can often court some risks not seen in traditional mutual funds. Investors should be aware of the precise differences between ETFs and ETNs so that they know exactly what to look for when choosing an index tracker.

First, let’s look at the similarities between the two products. Obviously, both ETNs and ETFs trade on exchanges just like stocks. But they can also be sold short and may even have options written on them, like stocks. Both ETNs and ETFs track the performance of a specific index, which can cover any area of the capital markets from equities to bonds to exotic exposures like volatility. Crucially, authorised participants (APs) can create and redeem shares of both products with the issuer for the net asset value of the underlying index, which creates the daily arbitrage opportunities that keep ETP shares close to fair value. Finally, ETNs and ETFs both charge fees which are deducted from returns.

As the names suggest, the largest difference between the two products is that ETFs are funds while ETNs are notes. Like a traditional open-end fund, an ETF derives its value from a basket of underlying securities. Owning a share in an ETF gives you a proportional equity stake in a trust which holds the underlying stocks, bonds, or derivatives. APs keep the ETF market price close to its net asset value through arbitrage by exchanging the basket of securities with the provider for additional shares, or vice-versa.

On the other hand, an ETN is not a fund, and does not directly hold any securities. Instead, an ETN is a promissory note similar to a bond whose principal value tracks the specified index. Like most other debt instruments, it represents a promise (but not a guarantee) from the specific issuer to pay back the principal amount. Unlike most other debt instruments, an ETN does not issue coupon payments or have an exclusive maturity date at which the principal will be paid. Instead, the principal amount fluctuates based upon the returns of the benchmark index, minus fees. APs may exchange ETN shares for the indexed principal amount at the end of each trading day or week, thus ensuring they keep the ETN trading close to the index value on exchange.

This lack of direct ownership on a pool of securities comes to the heart of the difference between ETNs and ETFs: credit risk. While an ETF can have counterparty risk depending on if it uses synthetic replication or if it lends out the underlying securities, it will always own a fund holding securities to mitigate this risk. A number of ETNs issued by Societe Generale and Barclays Capital in the UK and other European markets do not have any underlying collateral. If those ETN providers defaulted, investors holding shares would have to get in line as creditors along with the other debt holders. We saw this in practice when Lehman Brothers was the backing bank for three ETNs at the time of their 2008 bankrupts. While ETN issuers tend to be large banks where the risk of failure is low, many thought the same of Lehman Brothers before its fall. Investors should consider the issuer's credit rating when looking at investing in an ETN, and may want to look for ETNs that have pledged collateral securing their claims (thus increasing the chance of speedy and full payback in case of default).

That said, the ability to redeem ETNs at par with the issuer on a daily basis reduces (but does not eliminate) the risk of default. Because of this feature, ETNs generally do not trade with a credit spread discount. However, to take advantage of early repurchase directly generally requires redeeming shares worth several hundred thousand pounds sterling at one time, making most individual investors or advisers rely on the liquidity offered via market makers on the exchange.

So why do some investors use ETNs over ETFs despite the additional credit risk? ETNs eliminate tracking error, with the fees the only source of deviation from the performance of the index. Also, the ETN format can make it cheaper to invest in indices that would be difficult and expensive to replicate through a fund, like leveraged, volatility or emerging market indices.

So are ETNs right for you? The answer depends on the index being tracked, the balance between increased credit risk and decreased tracking error, whether or not the ETN is collateralised, as well as the liquidity and fees of competing products. As with any investment, it is important to know the underlying details. Consult the prospectus for the particulars behind an ETN.

This article first appeared on FT Adviser.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure.