Some believe that the introduction of exchange traded funds (ETFs) and exchange traded notes (ETNs) are the best thing since sliced bread, while others disagree. Some don’t even know what they are. One thing is for sure though: all investors who do play this market should know the similarities and differences between these two versatile tools.
ETNs are similar to ETFs in that they are traded on stock exchanges throughout the day, their performances mimic that of an index, and they allow access to specific and specialized markets and sectors like commodities and currencies.
The two biggest differences between the two are:
- ETNs, in essence, are bonds that don’t pay interest at a fixed rate, instead they pay an “implicit interest” which is a return on a designated index, states Ron Rowland of Money and Markets.
- ETFs are regulated by the Investment Company Act of 1940, ensuring investors some protection of the assets of the ETF in the case that the manager goes bankrupt. This is not so with ETNs, which are debt instruments that are only as good as the credit of the issuer. In other words, if the issuer goes bankrupt, you’re out the money you spent.
A recent example of this situation is the collapse of Lehman Brothers, which had three ETNs.
Another example of the difference between ETFs and ETNs from two that are currently trading are iPath S&P GSCI Crude Oil ETN (OIL) and United States Oil (USO). OIL enables investors to track the return of a crude oil index. When purchasing OIL, however, one is actually buying a promise from Barclays, the issuer of the ETN, to pay a return linked to the performance of the Goldman Sachs Crude Oil Return Index at some date in the future, not the actual commodity itself. This makes you an “unsecured creditor” of Barclays, and there are no guarantees that Barclays, or any other issuer, will refrain from filing for bankruptcy- remember what happened to Lehman Brothers.
On the other hand, investors purchasing USO are buying an ETF made up of futures contracts on oil. If the fund were to go under, investors will be able to buy and sell shares as they normally would. On the date of closing, trading ceases, and a short time later, all securities within the ETF are sold and distributed to the owner of record.
None of this means that an investor should not consider playing the ETN market, though. ETNs enable investors to access certain markets and sectors that are difficult to do so otherwise. But as with any product you invest in, it’s wise to understand the pros, cons and differences. If you do decide to add this versatile tool to your portfolio, be mindful of its inherent risks, do your homework, watch the trendlines and stay diversified.