Exchange-traded products typically refer to exchange traded funds and other exchange traded vehicles, such as exchange traded notes. However, ETFs and ETNs are not interchangeable as they are not structured in the same manner.
ETFs are not ETNs. Differentiating between the two products was pushed to the forefront after the TVIX debacle threatened to drag the overall industry down - we'll get to this part in a bit. Like any investment, investors should take the time to cover some due diligence and educate themselves before jumping into any area of the market.
First off, exchange-traded funds are exactly what their names indicate. They are funds that can be traded on an exchange and are registered under the Investment Company act of 1940. As a fund, the ETF security usually tries to passively reflect the performance of an index, a commodity or a customized basket of assets, similar to traditional index mutual funds.
ETNs, like ETFs, are traded daily on a stock exchange and track the performance of an underlying benchmark index. However, ETNs are registered under the Securities Act of 1933 and are issued as a senior unsecured debt note by a large bank.
Since ETNs are a form of unsecured structured promissory obligation, the funds are subject to the credit worthiness of the issuing bank - if the issuing bank falls on hard times and goes bankrupt, the investor may lose all of his or her principal. ETN investors basically make an uncollateralized loan to the issuing bank in exchange for returns of an underlying index. Unlike ETF products, investors cannot claim any underlying portfolio securities in the event that the financial institution goes bankrupt.
Most ETN issuers are large institutions with investment-grade ratings. Most investors would feel safe with these companies' products, but in the aftermath of the Lehman Brothers collapse, more observers are beginning to question the real worth of the bank industry's credit ratings.
In contrast, ETF investors are not subject to credit risks of the fund sponsors since investors hold a proportionate stake in a basket of securities held in a trust, which is legally separated from the assets of the ETF provider. Consequently, if the ETF provider goes under, the investor should be safe in his or her ETF holding.
Additionally, it even states in an ETN's prospectus sheet that "investors should be willing to lose up to 100% of their investment. If you hold your ETN as a long-term investment, it is likely that you will lose all or a substantial portion of your investment." However, the prospectus also notes that these products are meant for seasoned or knowledgeable investors who understand the funds and how they work. This is especially the case as more ETN products involve complex instruments for use in sophisticated hedging strategies.
Furthermore, ETNs have been manufactured on the promise of perfect tracking or limiting tracking errors between the funds' price and that of the underlying benchmark. However, unexpected costs are outlined on an ETN's prospectus sheets, which may cause tracking errors to the index, including "index calculations," "event risk hedge costs," "futures execution costs" and "holding costs."
The TVIX Drama
The recent premium run up in the Velocity Shares Daily 2x VIX Short-Term ETN (NYSEArca: TVIX) followed by the precipitous crash in assets and prices has put a blemish on the overall industry. Credit Suisse, the TVIX issuing bank, halted new issuances on new shares, effectively creating a limited supply of shares, but demand for the ETN product continued to skyrocket, which created a hefty premium - the purchasing price is above their indicative value. However, the dilemma came as prices suddenly plunged, coinciding with Credit Suisse announcing that it will issue new TVIX shares.