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ETFs Vs ETNs - VXX Vs VIX

|Includes:UVXY, iPath S&P 500 VIX Short-Term Futures ETN (VXX)

With the explosion of ETFs (Exchange Traded Funds) as trading mechanisms, it's no wonder that ETFs would develop into the realms of the absurd.

Like a bad spin-off from a '70s sitcom, ETFs spun off into ETNs (Exchange Traded Notes). The difference between the two is radical.

An ETF value is based on the price of its underlying holdings (like a mutual fund). The capital of the fund is secured by the value of the stocks held in the fund. An ETN is an unsecured, unsubordinated debt security with significant basis on the credit rating of the issuer. Although ETNs may be named to indicate tracking certain futures markets or indices, due to the fact that their holdings are credit notes rather than tangible assets, such as ETFs, their price becomes largely supply and demand based rather than based on underlying holdings. ETNs were originally developed to function in bond markets similarly to ETFs in equities markets. Presumably that should work because a bond, although a credit instrument, has an actual tangible monetary value.

Where ETNs went haywire was attempting to track indices not based on a monetary value. The Volatility Index (VIX) is a classic example. The VIX is a measure of options contracts traded on the S&P 500 over a 30 day period. It has no monetary value. It would be like trying to assign a dollar value to the numbers on a thermometer.

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Stocks: VXX, UVXY