The market for exchange-traded funds (ETFs) is bigger than you think. In addition to ETFs, market participants also trade exchange-traded notes (ETNs).
Though similar in scope and application, ETF and ETNs both contain important structural differences.
An Introduction to ETNs
ETNs are similar to their ETF cousins in that they are designed to follow an underlying asset. They also tend to be more affordable than mutual funds and can be traded on the major exchanges. The main difference is what goes on behind the scenes. Whereas ETFs represent an investment in a fund that holds the asset it tracks, ETNs operate more like bonds. That’s because an ETN is essentially an unsecured, unsubordinated debt whose value is based on a market index. ETNs also have no period coupon payments or protections.
An ETN’s value is largely driven by the credit rating of the issuer. If the issuer’s credit rating is downgraded, then the ETN could lose value. This comes despite there being no change in the underlying index.
Financial institutions usually issue ETNs at $50 per share. However, holding the asset does not entail ownership in a pool of securities. Instead, it merely provides exposure to the performance of a specific index. Upon maturity, the ETN is cashed out by the investor, minus applicable fees paid to the issuer.
Although ETNs are gaining prominence, they carry considerable risk for investors with little experience in the debt market. For starters, an ETN does not give you ownership of an underlying asset. Instead, it is merely a promise to the investor that he or she will receive a market return by the issuer if the note is held until maturity.
At the same time, the value of the ETN can change drastically regardless of underlying market conditions. As we mentioned earlier, an ETN’s value is largely at the mercy of the issuer’s credit rating. A downgrade from one of the major credit rating agencies could send the value of the fund tumbling. For some investors, this variable may be too risky to embed in their portfolio.
Investors also need to be aware of how ETNs are priced. This will avoid any unpleasant surprises down the road. For example, in 2012, the Financial Industry Regulatory Authority (FINRA) warned investors that the closing price of an ETN may be way off the actual value of the index it is tracking. This can be due to several reasons, but it’s usually based on high demand and inadequate share creations.
FINRA also warned of liquidity risk, price-tracking risk, holding-period risk and early redemption risks associated with ETNs.
That being said, ETNs do have their time and place, especially for experienced investors. The volatility market offers several ETNs that can be used to capitalized on investor anxiety. This is particularly important because the ETNs track the Chicago Board Options Exchange (CBOE) Volatility Index, which cannot be traded outright.
The iPath S&P 500 VIX Short-Term Futures ETN (VXX ) allows investors to “long” volatility by gaining exposure to first- and second-month VIX futures contracts that roll on a daily basis. In other words, the VXX rises when volatility rises.
On the other side of the spectrum, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV ) tracks inversely with the VXX, which means it rises when volatility falls. In other words, it trades in the same direction as U.S. stocks (i.e., S&P 500), albeit, three-to-five times faster. Investors who are bullish on stocks can benefit greatly from the VXX.
The Bottom Line
ETNs are the lesser-known cousin of the now-famous exchange-traded fund. Investing in the ETN market carries considerable risk so it’s best left to experienced investors who understand debt obligations.