Written by John Lounsbury
ETFs (exchange traded funds) are new kids on the block in the world of investing. Mutual funds have been in existence in the U.S. for over 100 years 
but ETFs only since 1993. But much of the buzz in the world of investing today revolves around ETFs rather than mutual funds. This is in spite of the fact that the amount of money held in mutual funds is more than ten times larger than money in ETFs. According to the Investment Company Institute, at the end of 2011 there was $23.8 trillion invested in mutual fund worldwide, $13 trillion in the U.S. According to Blackrock there was $1.8 trillion invested in all electronically traded products (ETPs) worldwide as of October 2012. In November 2012 the total in ETFs only was reported to be $1.3 trillion, indicating a sizable $500 billion invested in ETNs.
But ETPs are gaining assets much faster than are mutual funds. It is expected that sometime several years in the future the assets in ETFs and ETNs in total will equal and then probably surpass mutual funds.
As young as ETFs are, ETNs (electronically traded notes) are even newer; the first was issued in 2006 by Barclays Bank. It took 13 years for ETFs to reach a total of $500 billion invested; it has taken ETNs only half that long.
Both ETNs (Electronically Trade Notes) and ETFs (Electronically Traded Funds) are investment vehicles that trade like stocks on exchanges around the world. Many investors are not aware that the similarities are few and the differences are many. Investors should understand these differences before putting their money in one type of security or the other. We’ll discuss the differences and then present a few representative ETF and ETN investments.
ETNs and ETFs Differences
- ETNs are structured as debt securities (regulated under the Securities Act of 1933, while ETFs are structured as equity securities (shares in an investment company) and are regulated under the Investment Company Act of 1940.
- ETNs are generally unsecured debt and therefore could suffer losses should the sponsor go bankrupt (credit risk). ETFs are baskets of securities and therefore have a value independent of the existence of the issuer. This is something that should be a concern. Lehman Brothers and Bear Stearns went bankrupt in 2008 and both had issued ETNs. The Bear Stearns clients were rescued when those ETNs were transferred to JP Morgan Chase but holders of Lehman ETNs will have to wait a long time until bankruptcy proceedings determine how much, if any, they will recover.
- ETNs deal with underlying securities in a notional manner – they just track them and do not actually buy anything. ETFs, on the other hand, actually buy securities and that is what forms the value of the investment. Because of liquidity issues and trading spreads, the actual value of an ETF may deviate from the theoretical value (notional value). This deviation is called a tracking error. ETNs don’t have any tracking error.
- ETNs do not have to charge for transaction expenses for the underlying securities tracked because the structure of the notes is synthetic and not based on owning actual positions. Of course, if any trades are made in support of synthetic positions those cost would be subtracted from any gains, or added to any losses.
- Because ETNs do not buy and sell the underlying securities they provide a much simpler set of possible tax scenarios than do ETFs. ETFs, like mutual funds, can sometimes put holders in the position of having to pay capital gains taxes in years that they actually lost money because the fund has made trades during the year that resulted in realized capital gains while the value of the fund was declining in the same year.
- ETFs that utilize investments in futures contracts are required to be structured as partnerships resulting in the dreaded K-1 tax accounting forms. ETNs simply track futures when they are used and therefore avoid the cumbersome partnership accounting rules.
- Sometimes the cost of the debt instrument structures used in an ETN can be significant. In some situations the debt costs can equal or exceed ETF transaction costs.
- Because ETNs are less widely used and more thinly traded than ETFs they often have larger bid-ask spreads. This detracts from the relative gains trading ETNs.
Examples of ETFs and ETNs
Starting with ETFs we would be remiss not to mention the one that started it all and is still the largest:
- SPDR S&P 500 (NYSE:SPY) This index fund was first launched in the ETF category and remains king of the hill today with more than $123 billion in assets.
- SPDR Gold Trust (NYSE:GLD) The second largest ETF has $70 billion under management. It represents paper shares in gold bullion.
- Vanguard Emerging Markets ETF (NYSE:VWO): The third largest ETF, with $61 billion in assets under management, invests in what has been the fastest economic growth area.
- Invesco Power Shares QQQ (NASDAQ:QQQ): We have to go down to the seventh largest ETF to find one that invests in something other than the S&P 55 or emerging markets. This $32 billion fund invests in the 100 largest Nasdaq listed stocks.
- Vanguard Total Stock Market ETF (NYSE:VTI): The eighth largest ETF ($27 billion) tracks 99.5% (or more) of the U.S. stock market.
- iShares iBoxx Investment Grade Corporate Bond Fund NYSE(LQD): The largest bond ETF tracks the iBoxx $ Liquid Investment Grade Index of 600 investment grade corporate bonds. It is the ninth largest ETF overall with $24 billion in assets.
- Barclays TIPS Bond Fund (NYSE:TIP): The tenth largest ETF ($21 billion) tracks the Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index (Series-L).
The largest ETFs are all index funds. Actively managed funds have only been in existence since 2008 and have yet to establish any comparably large asset positions.
ETNs are based on tracking an index, often involving options or futures ciontracts. Some of the most popular:
- iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE:DJP): This tracks the Dow Jones-UBS Commodity Index Total Return. This ETN has a maturity date of 06/12/3036 and has a market capitalization of $2 billion.
- iPath S&P 500 VIX Short-Term Futures ETN Profile (NYSE:VXX): This tracks the S&P 500 VIX Short-Term Futures Index Total Return, with a maturity date of 01/30/2019. It has $1.1 billion market cap. This ETN offers an example of how dangerous some ETN investments can be. See below the five year chart from Yahoo. The loss from March 2009 peak is more than 98.8 percent. The danger is not just long-term. The loss for the year 2012 was 77.6 percent. Notice that the trading volume has been increasing over the years. It seems that some are finding VXX a useful trading vehicle.
Click on chart for larger image.
- PowerShares DB Gold Double Long Exchange Traded Note (NYSE: DGP): This is a double long leveraged ETN tracking the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold (200%). This ETN has a maturity date of 2/15/1938. The performance of DGP has exceeded its objectives. From October 2008 to the peak for gold in August 2011, DGP had a gain of nearly 500 percent. Gold gained 160 percent over that interval. Since the peak gold has declined about 13% while DGP has lost 29.7 percent. DGP significantly outperformed on the way up and has marginally underperformed since to top. The index that DGP tracks is based on gold futures contracts rather than the spot price of bullion.
- iPath MSCI India Index (NYSE:INP): This ETN tracks an index represent approximately 85% of the free-float-adjusted market capitalization of equity securities by industry group within India (MSCI India Total Return Index). It has a little less than $500 billion in assets and a maturity date of 12/18/2036.
- JPMorgan Alerian MLP Index ETN (NYSE:AMJ): One of the largest ETNs with about $5.5 billion in assets, this ETN tracks the Alerian MLP Index, which follows performance of Master Limited Partnerships (MLPs) in the energy sector, primarily in the energy infrastructure area, such as pipelines. This is an investment for those who are seeking dividend yield (currently 5.35 percent) as well as opportunity for capital appreciation. Over the past 3 ½ years AMJ has nearly doubled in price.
Summary
ETFs and ETNs are useful portfolio components. But investors who do not carefully study the prospectus of any investment in either of these two categories could end up with surprises instead of rewards. This is especially true of any who do not understand the differences between ETFs and ETNs.
See a related article on this topic at Investing Daily.
