What is an ETF? — Part 12: Exchange Traded Notes

May 18th at 7:00am by Tom Lydon

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 11: Actively Managed ETFs]

Investors have been using ETNs and ETFs almost interchangeably, trading in the belief that all exchange traded products act the same. However, ETNs are not ETFs, as many witnessed first hand during the VelocityShares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX) debacle that sent the ETN plunging 60% in just a few days. [What Really Happened with TVIX]

Unlike ETFs, an ETN is essentially an uncollateralized loan to an investment bank and leaves investors open to potential credit risks of the issuing bank – if the bank goes under, there is no guarantee that the ETN investor will receive all of his or her principle back.

It should be noted that ETNs are not registered under the Investment Company Act of 1940, which requires a fund to have a board of directors with fiduciary responsibilities and to standardize disclosures.

Since the ETNs are entirely in the hands of the issuing bank, the issuer may decide to halt new issuance of shares, essentially making the ETN act like a closed-end fund. Consequently, the ETN may experience extreme premiums or discounts since there are no opportunities to create or redeem ETNs to keep the share prices close to the indicative net asset value.

Additionally, ETNs may issue some hidden fees investors are not aware of, which may lead to tracking errors, or deviations in ETN performance, to the underlying index. [Morningstar Warns on ETN Fees]

For instance, some ETNs issue path-dependent fees, event risk hedge cost, futures execution cost or index calculation fees, all of which may contribute to higher tracking errors.

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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