The SPDR S&P 500 ETF (SPY) began trading in January of 1993. That was the first exchange traded fund, and we’ve seen quite the evolution since then. Flash forward 22 years and ETFs have become a market fixture. From ETFs we’ve seen another exchange traded product develop: exchange traded notes or ETNs.

Exchange traded note…exchange traded fund…sounds similar enough, right? Not so fast. These investments may sound similar, but they have some stark differences that investors must know about.

Let’s begin with how exchange traded funds and exchange traded notes are similar: Both ETFs and ETNs track an underlying index, tend to have lower expense ratios than actively managed mutual funds, and trade on exchanges. That’s where the similarities end though.

Exchange traded funds (ETFs) are a topic we’ve discussed previously. You can check out our other ETF related posts here: https://mullooly.net/tag/exchange-traded-funds/ To summarize, an ETF is a basket of securities that tracks an index. An ETF is legally separate from its managing company. The managing company could cease to exist and investors would still own the assets held by the fund.

Exchange traded notes (ETNs) are unsecured debt securities. This surprises most people because ETNs typically track an emerging market, commodity, foreign currency or market volatility index. However, the investment is technically a bond issued by a financial institution. ETNs have maturity dates, like bonds, that are usually far off in the future. The financial institution promises to pay investors the underlying index’s return.

As you can see, these two exchange traded products generate income in very different manners. One generates income from the actual ownership of securities and the other is a promise to pay income based on the faith and good credit of a financial institution. However, many investors assume they’re the same because of their similar names and the characteristics they do share.

Credit risk is the biggest difference between ETFs and ETNs. As we explained earlier, investors in ETFs do not have to worry about credit risk. If an ETFs managing company disappeared, the investors would still own the basket of securities. However, if the issuer of an ETN defaults or goes bankrupt, its investors will be treated like all other unsecured debt holders of the company. Return of investment is not guaranteed.

The 2008 failure of Lehman Brothers provides us with an excellent example of ETN investor credit risk. While this example is obviously extreme, it goes to show that these things do happen. Three Lehman Brother ETNs ceased trading when the company failed in 2008. Michael Iachini of Schwab describes the scenario in a post stating:

“Any investors who did hold shares of these ETNs when Lehman Brothers went bankrupt ended up waiting in bankruptcy court with everyone else who’d loaned money to the firm, hoping to get a few cents on the dollar for their investment.”

Investors who weren’t aware of ETN credit risk before the Lehman episode were hopefully awoken afterwards. That’s a costly way to learn a lesson.

The purpose of this post was not to say that ETFs or ETNs are better/worse than each other. Both investments could hypothetically have a place within the right investor’s portfolio. That’s something individuals need to discuss with an investment advisor.

The message we want to send is that investors must know what they own! Knowing what you own means understanding your investments and how they generate returns. When you don’t understand your investments, unpleasant surprises may occur. That’s why we produce podcasts, videos, and posts here on our site, to educate investors.

 

Sources:

http://www.finra.org/investors/protectyourself/investoralerts/tradingsecurities/p131262

http://alletf.com/content/etfs-versus-etns

http://www.schwab.com/public/workplace/nn/articles/Exchange-Traded-Notes-The-Facts-and-the-Risks

Now Go Talk About It!