A suite of exchange traded notes (ETNs) recently stopped issuing new shares as a result of an operational issue, leading to a 24% premium on one of the notes to its net asset value.1 Another black eye for ETNs, it also serves as a reminder of how vastly different they are from exchange traded funds (ETFs).
Let’s start with the basics. Exchange traded notes (ETNs) are unsecured debt instruments that seek to track a reference asset (e.g., a niche market sector, the return of the S&P 500® Index, or the movements of the CBOE VIX Index). Typically issued by banks, ETNs trade on an exchange like stocks.
An exchange traded fund (ETF) is a pooled investment that either seeks to track an index or is actively managed. ETFs can be purchased or sold on an exchange just like a regular stock.
There are three key differences between ETNs and ETFs:
Investor counterparty risk
Use of derivatives
1. Investor Counterparty Risk: ETNs Have It, ETFs Do Not
ETNs are unsecured debt instruments, or “notes,” issued by a bank. As a result, they carry the counterparty risk of the issuer.
An ETF, however, is a fund backed by underlying holdings – typically stocks or bonds. The counterparty risk, from the investor’s perspective, is negated. This is because the ETF’s holdings are fully backed by underlying investments and are not reliant on a counterparty’s ability to repay an investment.
For example, if there were an ETN on high-tech stocks (e.g., FANG stocks), and those stocks rallied by 1,000%, that would be great, right? Well, with ETNs, it’s complicated. If the issuing bank does not have the capacity to pay the investor when they want to redeem, the investor doesn’t get their money back.
Consider this. If the bank that issued the note were to go bankrupt (e.g., Lehman Brothers and the three notes they issued), the investor would risk a total default on the note. To get any money back, they would have to get in line with all of the bank’s other creditors in the bankruptcy process.
A return on an ETN is a function not just of the underlying reference asset’s return, but also the issuing entity’s capacity to pay.
For an ETF, the investor’s shares are fully backed by the securities the fund holds. Using the same example as above, the fund would sell the underlying securities to meet the redemption. As a result of the ETF’s in-kind creation-redemption process, the underlying securities would be distributed out of the fund to a market maker or Authorized Participant in return for the ETF shares that the end investor sold.
As a result, an ETF’s return is based on the return of the underlying assets2 – not on the ETF sponsor’s (e.g., an asset management firm) ability to repay an investor for their shares.
2. Use of Derivatives: 100% for ETNs
To obtain the underlying reference asset exposure and payoff profile, ETNs will explicitly use derivatives like futures or swaps and will not hold physical securities, such as bonds, stocks, or commodities.
Given the use of derivatives that are typically price-return securities — meaning they do not usually produce an income stream — most ETNs do not pay any dividends. This is a bit antithetical to the notion of ETNs being a debt security, as debt instruments usually produce income.
While there are some levered and inverse ETFs that use derivatives to obtain exposure, the majority of ETFs do not. In fact, only 1.3% of all US-listed ETF AUM is in funds that use only derivatives for implementation.3
3. Costs: Higher for ETNs
The average fee for an ETN is 75 basis points (bps), while the average fee for an ETF is 55 bps.4 And there are some ETFs that have fees as low as 3 bps, while the lowest-fee ETN is around 45 bps.5
There are also higher costs in terms of trading, as some ETNs trade less than 100 shares a day and have wide bid-ask spreads, as well as more volatile premiums/discounts — the latter evidenced by the recent events on that one note.6 In fact, the median daily volume over the last three months for ETNs is just $217,000 a day as compared to $1.1 billion for ETFs.7
The Takeaway? ETNs Are Not ETFs
While their names sound similar, their differences are stark. An ETN is an unsecured debt instrument that uses derivatives to obtain exposure while charging high fees. And ETN investors could lose their entire investment based solely on the creditworthiness of the issuer.
Alternatively, ETFs are fully backed pooled investments with fees as low as three bps. And an investor’s return depends on how the stocks or bonds in the fund perform, not if the company behind the fund has a credit event.
Investors will want to do their due diligence not just when selecting specific funds, but also when evaluating investment vehicles, to ensure they understand the potential benefits as well as the risks. Review fund documents for full details, and be sure to speak with a local sales team member who can help answer any questions you may have.
1 Bloomberg Finance L.P., as of March 28, 2022. Premium is the current stock price versus net asset value. 2 An ETF’s return could also be minimally impacted by the premium/discount of the fund if purchased on the secondary market. 3 Bloomberg Finance L.P., as of March 28, 2022. Based on calculations from SPDR Americas Research. 4 Morningstar, as of March 28, 2022. 5 Morningstar, as of March 28, 2022. 6 Bloomberg Finance L.P., as of March 28, 2022. Based on calculations from SPDR Americas Research. 7 Bloomberg Finance L.P., as of March 28, 2022. Based on calculations from SPDR Americas Research.
CBOE VIX Index A measure of implied market volatility on the S&P 500.
FANG An acronym for the technology stocks Facebook, Apple, Netflix and Google.
S&P 500® Index A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.
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