ETF Univ: What Is An ETN?

ETNs are very similar to ETFs, but there are some key differences.

[This article appears in our January edition of ETF Report.]

Investors typically use the term “ETF” to mean a lot of things that aren’t technically “exchange-traded funds,” a roster that includes the exchange-traded note (ETN), which is the most important of these additional structures.

ETNs are debt notes issued by a bank. When you buy an ETN, the bank promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN will increase if the gold price goes up.

The beauty of the ETN structure is that it can be linked to anything. There are ETNs that track commodities, and ETNs that track hard-to-reach corners of the equity market. They sometimes combine stock or bond positions with options overlays, or use other sophisticated strategies that would be difficult to package into a traditional ETF. In the commodity space, the ETN also offers significant long-term tax advantages compared with most ETFs.

The downside of an ETN is that if the underlying bank goes bankrupt, you lose essentially all of your money. There were, for instance, a few ETNs backed by Lehman Brothers. While most investors in Lehman’s ETNs fled before the firm shut down, anyone who held to the bitter end probably still has a bad taste in their mouth.

The good news is that this credit risk in most situations is minor. Institutional investors can “redeem” (get their money back) from the underwriter of ETN daily. While anything can happen, you usually see major bank defaults coming more than a day or two ahead.

The even-better news is credit risk is easily monitored. FactSet monitors and reports on the credit risk of every ETN daily, and the data appears on the ETF.com website. The data provider does that by watching the cost of credit default swaps (CDS) on the underwriting banks each day. CDS are like insurance—investors buy them to protect themselves against a company’s default—so they are the best possible view of the likelihood a bank will go down.

How do you check? Just pull up the Efficiency Tab on any ETN (e.g., www.etf.com/AMJ) and check out the ETN Counterparty Risk measure. If it says “Low,” you’re OK. If it says “High,” run for the hills.