Market Beat: The difference between an ETF and an ETN
March 9, 2012
TRUCKEE, Calif. andamp;#8212; The last few years have seen an explosion in the number of ETFs (exchange traded funds) on the market. The very first ETF was launched in Canada in 1989; it tracked the Toronto 35 Index. The first ETF in the US was the Spyder, which tracks the Sandamp;P 500 index. It was launched in 1993 along with the Diamond, which tracks the Dow Jones Industrial average. By 2002, there were more than 200 ETFs trading, and today the number is more than 1,000.With an ETF, the investor is exposed to market risk because the ETF will track an underlying index and is also exposed to a type of risk known as andamp;#8220;tracking error.andamp;#8221; Tracking error means that the performance of the ETF may not match its underlying index exactly. The Spyder tracks the Sandamp;P 500 but can vary slightly due to trading costs and other expenses. The Spyder holds the stocks that make up the Sandamp;P 500 index, so if an investor decides to sell, he or she will get the price of the Spyder at that time which will be very close to the value of the Sandamp;P 500.In recent years along with the ETF explosion there has been a new type of exchange traded fund, which is known as an exchange traded note or ETN. One advantage of ETNs is they can reduce or eliminate tracking error. But they also carry an additional risk that ETFs donandamp;#8217;t have and that is credit risk.They are issued as senior debt notes by a bank, with a maturity date, and as a consequence carry credit risk like bonds. The investor in an ETN receives a promise to be re-paid by the issuing bank. So even though the ETN may track a stock index, its price can be influenced by the credit rating of the issuing bank.Barclayandamp;#8217;s Bank was the first issuer of ETNs and is the largest participant in the market. It is a AA credit rating, itandamp;#8217;s more than 300 years old and has $1.5 trillion in assets. Its reputation is solid, but an ETN investor is still exposed to the risk of the bank failing. Barings Bank was another large bank with a great reputation that had financed the Napoleonic wars. Barings failed because of the actions of one rogue trader.ETNs can be useful investment products, but investors need to be aware of the additional risks and use them appropriately.Kenneth Roberts is a Truckee based Registered Investment Advisor. Ken has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm, and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-657-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.