It’s hard to find an investor who isn’t at least familiar with the term ” exchange-traded fund” by now. ETFs assets now sit at about $3 trillion worldwide, and Goldman Sachs believes that number will expand to $6 trillion in just five years.
Less known (and understood), however, are exchange-traded notes — slightly more exotic instruments that function like ETFs, but with some serious structural differences.
But because ETFs and ETNs are so similar and so disparate at the same time, many investors are left to wonder: Are ETFs better than ETNs?
Well, many investment questions are like asking, “Is chocolate OK to eat?” The answer is, “It depends.” How much chocolate do you plan on eating? How was the chocolate made? Are you a dog?
So when it comes to ETFs versus ETNs … well, it depends.
What is an ETN, anyway? Let’s go with the quick version. The “note” in “exchange-traded note” refers to the fact that the product you’re buying is actually a debt note — one that is used to track some sort of index as part of an investment strategy. When you redeem that ETN, you’re promised whatever that strategy would have returned (backing out fees, of course).
“The chief difference between an ETF and an ETN is that the ETF owns the stocks and bonds that make up the portfolio, while the ETN is merely a note that pays the return on the portfolio,” says Joseph LaCorte, president of S-Network Global Indexes Inc.
And because of that structure, ETNs can do many things ETFs can’t.
The upside. For instance, ETNs are used to create “leverage” — when a fund returns two or three times the daily return of an index. Obviously, investors can’t get double the returns on stocks simply by holding them — but ETNs don’t have that limitation.
ETNs have a few other benefits as well. For one, because they’re simply debt notes, ETNs can precisely track their index — something that ETFs can occasionally struggle with because of the constant fluctuation of their holdings’ prices and the numerous trades they have to execute to maintain their proper proportions. This issue hampered investors during the “Black Monday” decline of Aug. 24:
“Since ETFs are prone to tracking error versus their underlying basket of securities, wide price disparities can materialize, such as the rapid decline in the Guggenheim S&P 500 Equal Weight ETF (ticker: RSP),” says Anthony Mirhaydari, editor of the Edge and Edge Pro trading newsletters. “At its worst, the ETF was down some 50 percent on the day; despite a mere 4.5 percent decline in the underlying S&P 500 Equal Weight Index at the low of the day. For investors that had good-until-canceled market order stop losses well below the prevailing price, it’s possible the order was filled at a level that really shouldn’t be considered ‘true’ — resulting in deep losses.”
And sometimes, ETNs actually can offer a better way to invest in a particular area of the market. David Fabian, managing partner and chief operations officer of FMD Capital Management, says that while he typically prefers ETFs for clients, ETNs can provide at least one advantage: “In the case of commodities, an ETN may be a more advantageous choice to skirt the tax headache of a K-1 that an investor would receive in a comparable ETF.”
The downside. LaCorte also points out that ETNs’ structure — namely, that they are debt — comes with a unique risk: “As a result, the investor assumes the credit risk of the issuer of the note,” he says. “Most issuers of ETNs are large banks, so this credit risk is minimal. But investors should always keep in mind that when they buy an ETN, they are buying a bank note, not stocks and bonds.”
In other words, if the financial institution backing your ETN goes under, so will your ETN.
The banks that do the issuing — including Barclays (BCS) and Credit Suisse Group (CS) — aren’t exactly fly-by-night names, so this risk doesn’t come into play often. But it’s important to note that this can happen (and has happened). Lehman’s 2008 bankruptcy dragged its Opta ETNs into the murky deep, and many other ETNs were rocked as investors bailed in fear about the health of their ETNs’ issuers.
“When selecting an ETN, pay particularly close attention to the financial strength of the issuer,” Fabian says, “and the size and liquidity of the fund, as well as embedded expenses.”
Also, that aforementioned leverage can be awfully dangerous — after all, while a fund might be able to provide you with double or triple the gains, they can also deal you double or triple the pain. But that’s hardly an ETN flaw — that’s simply a strategy that’s offered, and it’s your decision whether to utilize it.
So, which is better? Not to beat a dead horse, but again, the answer remains, “it depends.”
Very rarely is there an exact overlap between ETF offerings and ETN offerings. You have a few, such as commodity funds. Or there are funds like the iShares MSCI India ETF (INDA) and the Barclays iPath MSCI India Index ETN (INP), which track the same MSCI index. However, that matchup is mostly a wash. While the ETN’s better tracking quality has led to slightly better total returns, its higher expense ratio eats that extra return (and then a little extra).
Instead, what you’ll typically find is that ETFs offer more straightforward exposure to stocks, bonds and other assets, while ETNs offer leveraged, inverse and other exotic exposures.
So at the end of the day, while ETFs and ETNs sport a couple of advantages and disadvantages, the battle of ETFs versus ETNs mostly comes down to what you’re looking for in an investment or trade.
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Which Are Better: ETFs or ETNs? originally appeared on usnews.com
