Exchange traded notes (ETN) are structured investments linked to market instruments such as market Indices, Commodity, Currency, Emerging Markets, Fixed Income, Leveraged products and Strategies.
Introduced on June 12, 2006 by Barclays Bank, the first ETNs named iPath, was issued as unsecured debt which means such notes don’t own anything while ETFs represent a stake in an underlying security.
Therefore dealing with ETNs means dealing with credibility (credit risk) of an issuer.
Soon, other global investment banks issued their ETNs: Bear Stearns, Goldman Sachs, UBS, BNP Paribas, Lehman Brothers, Morgan Stanley, Credit Suisse and Deutsche Bank.
Bear Stearns listed its first BearLinxSM Alerian MLP Select Index ETN on NYSE on July 20, 2007. The ETN was linked to the Alerian MLP Select Index (ticker: AMZS).
The NYSE said it was the eight such product to list on the exchange and Barclays Bank was the sole provider.
JPMorgan Chase & Co. withdrew the NYSE Arca listing of its BearLinxSM Alerian MLP Select Index ETNs on or about June 15, 2009 after credit crunch of Bear Stearns.
MAIN DIFFERENCIES: ETF and ETN
1. ETFs are true investments, ETNs are unsecured bonds without par value redemption at the maturity and no usual interest payments during the life of the bond.
Instead, the redemption value is linked to the performance of the underlying. Most ETNs do not provide for any periodic payments until sale or maturity.
Some ETNs that make periodic payments typically net out annual fees beforemaking such payments.
2. ETFs have market risk only while ETNs also have prepackaged credit risk. ETNs Market risks can also be different due to some components that can be traded in foreign currencies and are subject to currency risks.
ETNs may have call features. ETNs can be subject to early redemption or an “accelerated” maturity date at the discretion of the issuer. A call right or early redemption may adversely affect the value of the notes.
3. ETFs strategies are simplier in their nature because there are real underlying assets held by a separate custodial institution. Therefore exotic strategies are difficult to replicate. ETNs are more flexible and focus on different possible strategies including exotics where ETFs are unavailable.
4. Costs of holding ETFs are simple, low and transparent. The main disadvantage of ETNs are their fees and hidden costs. To structure ETN, different aspects should be taken into consideration. The first one is a correlation between assets that can be difficult to recognize and therefore a client can pay additional expenses for risk hedge cost without knowing them. The second one is future execution.
Also there are redemption and transaction fees to take into account. With other words, it is clear that somebody should pay to ensure there is no tracking error!
5. ETF can have tracking error which can result in under performing relative to the underlying while ETF guarantees full return.
6. Both are sold on Stock Exchange with more or less the same expense ratio but it varies depending on underlyings. Fees associated with ETNs can be anywhere from 0.30% to 1.25%.
7. Institutional size redemption may differ: ETFs on a daily basis, ETNs weekly.
8. Tax treatment can be different.
9. Conflicts of Interest can play important role between investors and the issuer of ETNs if the issuer is engaged in trading activities that are at odds with investors. Also, it is important to understand that issuance/redemption of notes can bring the price up or down.
CBOE offers American-style option contracts on ETF (Whenever a short position is held in an American-style option contract, there is risk to be assigned on the short position). It is important to make difference between ETF options and Index options.
For example, if an ETF option is exercised, the result would be a transaction of 100 shares of the underlying ETF. Index options are cash settled.
CBOE offers options on Exchange Traded Notes (ETNs) that have a term of at least one year but not greater than thirty years and physically settled with an American-style exercise feature.
LEVERAGE and INVERSE
Both ETFs and ETNs can have leveraged exposure with long and short exposure. Leveraged investing has gained increasing popularity among investors. An ETN that offers 2x leverage promises to pay twice the performance the underlying it tracks. Some leveraged instruments can track a fixed multiple of performance of the underlying.
Inverse ETNs offer to pay the opposite of the performance of the underlying it tracks, and leveraged inverse ETNs will pay a multiple of the opposite of the performance of the underlying. Some ETNs achieves their returns on a daily basis and reset their leverage or inverse exposure on a daily basis.
Some iPath ETNs offer so called indicative leverage value based on the current Intraday Indicative Note Value published by NYSE Arca, so an investor knows exactly how much the leverage is. Once leveraged iPath ETN bought, the leverage factor never resets.
CONCLUSION and CHECK LIST
1. What is the issuer’s credit rating?
2. What can be with the issuer if next credit crunch come to the market?
3. Is ETN liquid? Is it leveraged, inversed? Does it have “reset” future?
4. Is it callable or with early redemption?
5. What is the issuers size?
6. What underlying does it track?
7. Make sure, all fees and costs are transparent
It is preferable to buy ETFs instead of ETNs for private individual investors.