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ETFs vs. ETNs: Why You Need to Know the Difference

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The most popular exchange traded product to bet on volatility-- the iPath S&P 500 VIX Short Term Futures ETN (VXX)--expired last week and was replaced by iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB - Free Report) . Volatility linked exchange traded products came into focus last February when they were blamed for exacerbating the market sell-off.

Credit Suisse and Nomura shuttered their inverse volatility exchange traded notes (ETNs) after they lost more than 90% of their value as VIX soared 115% to its highest level in more than two years.

Many investors do not understand the differences between ETNs with ETFs and risks associated with investing in ETNs. In fact, the SEC is considering a proposal for better labeling of exchange traded products, including ETNs.

ETNs are unsecured debts issued by a major bank. Unlike ETFs, ETNs do not actually hold any securities, instead the issuing bank promises to pay to investors the amount reflected by the index’s performance minus fees.

Being debt instruments, usually unsecured debt by the issuing institution, ETNs face some level of credit risk. This means that if the issuing firm were to go bankrupt, investors may not receive their full investment back, if anything at all.

That actually happened with three ETNs sponsored by Lehman Brothers, when that firm filed for bankruptcy in 2008.

Further, since ETNs are debt instruments, they have a maturity date—usually about 30 years after the issuing date—when the note’s principal is paid out to investors.  Some ETNs can also be called in by their issuer before the maturity date.

ETFs on the other hand face neither of these issues; they are perpetual and even if an issuer of ETFs goes belly-up, investors' capital remains safe and secure.

At times, providers decide to liquidate notes for some reason. If this happens, the liquidity for the ETN can dry up or just evaporate.

Usually ETNs trade at fair prices, i.e. close to their intrinsic values. But at times certain ETNs’ prices deviate from their NAVs and they can trade at a premium or discount to their NAVs. If you buy an ETN when it is trading at a premium, you can incur losses if you sell after the premium crashes.

These price disruptions usually occur when for some reason the ETN sponsor suspends creation mechanism.

To learn more, please watch the short video above.

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