But ETFs are no longer the only exchange-traded product (ETP) on the block. Other, generally more speculative, issues called exchange-traded notes (ETNs) have joined ETFs on public exchanges, offering investors yet more opportunities to gain exposure to different underlying assets and indices. But what are ETNs? How do they work—and what makes them different from ETFs?
.jpg?width=880&height=587&name=shutterstock_1099878122%20(1).jpg)
On January 22nd, 1993, Boston-headquartered asset management firm State Street Global Advisors’s SPDR S&P 500 ETF Trust began trading on the New York Stock Exchange under the ticker symbol SPY.
The world’s first exchange-traded fund (ETF) in existence, SPY allowed investors to track the performance of the S&P 500 index.
On its own, that was nothing new. Jack Bogle’s Vanguard Group had pioneered the first S&P 500 mutual fund nearly two decades prior when he launched the Vanguard 500 Index Fund (VFINX) on August 31st, 1976.
But the concept of an ETF was new. Unlike mutual funds, which only trade once per day at the closing bell, ETFs could be purchased or sold throughout the trading day. This key innovation meant that ETF investors would have access to the same real-time quotes and intraday liquidity enjoyed by holders of publicly-traded corporate stock.
Liquidity aside, ETFs lowered the barrier to entry for small-scale retail investors. While ETFs could be purchased for the price of a single share, mutual funds often came with higher minimum investment amounts—usually ranging between three and five figures. (For example, as of March 31st, 2023, SPY trades for $409.31. VFINX, meanwhile, requires a minimum investment of $3,000.)
ETFs were also more tax-efficient than their mutual fund counterparts. While mutual funds sometimes distributed capital gains to investors—even if they did not sell any of their mutual fund holdings—ETF investors would be shielded entirely from capital gains during their holding period, realizing gains only if they sold their shares.
Thanks in part to these reasons, ETFs have become a mainstay of the investment universe. Today, there are 1,780 ETFs in the United States. Collectively, they boast $5.26 trillion in assets under management (AUM). As for SPY, it’s currently the world’s largest ETF, having amassed $367.6 billion in AUM.
But ETFs are no longer the only exchange-traded product (ETP) on the block. Other, generally more speculative, issues called exchange-traded notes (ETNs) have joined ETFs on public exchanges, offering investors yet more opportunities to gain exposure to different underlying assets and indices. But what are ETNs? How do they work—and what makes them different from ETFs?
ETN’s: A Primer
Officially, ETNs are bond securities that trade on public exchanges. But unlike some bonds, ETNs aren’t secured by collateral. And unlike most bonds, they pay no interest.
Rather, an ETN’s performance is tied to a market index. When the ETN matures—usually between ten to 40 years after inception—noteholders will be paid out based on the value of that index at the time of maturity.
Because ETNs are publicly traded, however, these securities can be bought or sold on an exchange well before their maturity dates. In fact, most ETNs aren’t designed to be held to maturity at all.
Volatility ETNs
Take VXX, for instance. Officially the Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN, this long-volatility product with over $600 million in AUM “offers exposure to a daily rolling long position in the first and second month VIX futures contracts.”
What does this mean? Colloquially, the VIX can be thought of as the market’s fear gauge. The technical definition of the VIX is significantly more nuanced, and can briefly be summarized as a “measure of constant, 30-day expected volatility of the U.S. stock market derived from real-time, mid-quote prices of S&P 500 Index…call and put options.”
Futures, on the other hand, are derivative contracts that create an obligation between two parties to buy or sell a security at a certain price on a specified future date. This means that VIX futures are contracts that “reflect the market’s estimate of the value of the VIX Index on various expiration dates in the future.”
As these futures contracts near maturity, they decay in value and converge with the value of the VIX. Because of this, investors who hold either VXX ETN or VIX futures outright will systematically lose money over time, unless a sudden shock causes the VIX (and thus the price of both VIX futures and VXX) to skyrocket.
The VXX prospectus does not mince words when addressing this risk: “The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.”
So why buy this “toxic” ETN at all? Like many volatility products, VXX is meant to be a short-term hedge against broad-market downside risk. Unlike ETFs like SPY, VXX is not a buy-and-hold instrument. Instead, investors who purchase VXX see it as a way to profit from a temporary spike in volatility—and will rapidly exit their positions after the fact.
Less-Toxic ETNs
That said, not all ETNs exhibit such extreme performance. The world’s largest ETN by AUM, the $2.6 billion J.P. Morgan’s Alerian MLP Index ETN—which trades under the ticker AMJ—is an exchange-traded note that “tracks an energy infrastructure Master Limited Partnership (MLP) index.”
MLPs are publicly-traded partnership structures that combine the pass-through tax benefits of a partnership with the characteristics of a publicly-traded entity, and the AMJ ETN wrapper provides investors with exposure to a specific underlying index of MLPs.
ETFs and ETNs: How They Compare
Crucially, though AMJ (and ETNs generally) track the performance of an underlying index, they don’t actually own any of the components of the index itself. Because of this, investors who own ETNs inherently assume credit risk, since the value of these securities are predicated on little other than the creditworthiness of the sponsors who issued them.
Full Replication ETFs
ETFs are usually—though not always—different. Funds like SPY are full-replication ETFs, which mean that they hold every single component of the underlying index. The SPY unit investment trust, therefore, holds 503 common stocks in a capitalization-weighted manner—exactly as its underlying index, the S&P 500, does.
Index Sampling or Optimization ETFs
Other ETFs use a sampling (a.k.a. optimization) strategy, where the fund holds a representative sample of the securities in the underlying index. Usually, ETFs opt to sample the underlying when full replication is prohibited by cost or liquidity constraints.
For instance, Vanguard’s Total Stock Market ETF, which trades as VTI, tracks the CRSP US Total Market Index. With nearly 4,000 constituent companies—the smallest of which has a market capitalization of $1 million—it would be impractical for VTI to fully replicate this index.
For this reason, VTI uses an index-sampling strategy that makes use of statistical techniques to minimize tracking error, or deviations between the performance of the ETF and the underlying index.
On that note, some ETNs—provided that the issuer is sufficiently creditworthy—may exhibit no tracking error whatsoever, since they do not hold any of the underlying and thus do not track it to any literal extent.
Synthetic ETFs
Finally, synthetic ETFs are most similar to ETNs in that neither hold the underlying index in any capacity. Instead, synthetic ETFs attempt to replicate the performance of an underlying benchmark by using derivatives like options and swaps.
This means that synthetic ETFs, like ETNs, are subject to counterparty risk—the risk that the party on the other side of the derivative contract, usually a bank, will default on its obligations to the fund.
At TSG Alpha Partners, our seasoned financial advisors work with you to define your financial goals, optimize your investment choices, and grow your wealth.
Whether it’s investing in mutual funds, ETFs, or ETNs—or even private alternatives—we’re dedicated to finding investments that can help you achieve your financial goals.
