In January of 1993, the first Exchange-Traded Fund (ETF), SPY, was introduced. Nearly a decade later in 2002, Morgan Stanley introduced the first Exchange-Traded Note ((ETN)). The growth of exchange traded products has been exponential since their first introduction. At the end of 2016, there were a total of 4,779 Exchange-Traded Funds (ETFs) and 546 Exchange-Traded Notes (ETNs)[i]. Today, investors have access to products that seek to track the performance of nearly everything from plain vanilla indices to vanilla extract. While it is easy for investors to differentiate the investment strategies of ETFs and ETNs, the underlying differences between the two types of products are not so readily apparent. As John Wooden has eloquently stated, “It’s the little details that are vital.”
ETFs and ETNs share several similarities, which blurs the line of differentiation. Superficially, the names and acronyms are very similar. ETFs and ETNs share two of the same words: “exchange traded”. ETFs and ETNs both provide investors with an easy means of investing in various market segments. Both typically have relatively low costs in comparison to accessing the underlying investments separately. Both trade on exchanges accessible via a few clicks on the computer or a few words on the phone with a broker. Adam Smith’s hands guide the prices in the market. ETFs and ETNs both seek to track a specified index or investment methodology. On the surface, both ETFs and ETNs appear to be the same; however, the underlying structure of the two products is vastly different. In July of 2012, FINRA issued an Investor Alert titled, “Exchange-Traded Notes – Avoid Unpleasant Surprises”, which outlined the fundamental differences between these two products. The SEC issued an Investor Bulletin in December of 2015 explaining the key risks of ETNs.
Some of the primary structural differences that are materially important for a potential investor to understand are:
- Ownership Structure (Asset vs Debt)
- Share Creation / Redemption Process
- Tax Treatment
Starting with the most important difference between ETFs and ETNs is the ownership structure. ETFs are an asset, and ETNs are a liability. This distinction matters and can materially affect the price / performance of the underlying product. If an investor holds an ETF, they OWN the actual underlying investments. There are actual stocks, bonds, future contracts, or bars of precious metals held at a custodian bank. If an investor holds an ETN, they own a debt instrument issued by a bank or investment firm. There is no asset sitting in a custodian bank for safe keeping. Effectively, ETN holders own a bond backed by the credit worthiness of the issuing institution. In other words, ETF holders are owners of an asset and ETN holders are lenders whose “interest rate” is based upon the performance of a selected index.
Stressing the ownership structure to its most extreme, bankruptcy, the difference between the ETFs and ETNs is easier to understand. For example, Big ETF files for bankruptcy and an investor owns their Big Stock ETF. In the case of bankruptcy, the ETF investor would be delivered shares of the actual stocks that were held in the ETF. The investor would suffer no loss and would own the same stocks after the custodian bank delivers the actual shares held by the fund. In reality, it is more likely that another firm would step in to take over management of the fund, which would end in the same result: no impact to the ETF holder. The ETF holder would own the same stocks or investments, even if the provider of the ETF went bankrupt.
ETNs are completely different. ETNs are debt issued by a bank, which are typically senior unsecured debt that PROMISES to pay a return based upon an index. For example, Big ETN files for bankruptcy and an investor owns their Big Equity ETN. In the case of bankruptcy, the holder of the ETN becomes a creditor of the firm. The amount of money an ETN holder would receive would be dependent upon the amount of money available after employees, Uncle Sam, and senior secured bond holders get paid. Even if the underlying index of Big Equity ETN is hitting record highs, the actual value of the ETN is likely to be pennies on the dollar since Big ETN cannot make good on their promise to pay a return.
Since ETNs are a bond with an interest rate set to the return of a selected index, the price of the ETN will be influenced by the credit worthiness of the issuing firm. The price of an ETN is influenced by the performance of the selected index and the ability of the issuing firm to pay. The market is likely to discount the price of the ETN below the indicative value if the issuing firm’s credit rating declines or if the market believes that the issuing firm’s ability or willingness to pay is impaired.
Examining a real life example, DBO and OIL are two products that seek to track changes in the price of crude oil. DBO is an ETF, and OIL is an ETN. DBO directly holds futures contracts. OIL, per their prospectus, “is not the same as owning interests in the commodities futures contract comprising the index”. In addition, the prospectus for OIL outlines how performance can be affected by their creditworthiness: “consequently, actual or anticipated changes in our credit ratings may affect the market value of your ETNs.”
Returning to our extreme credit risk example, what if the issuers of DBO and OIL filed for Bankruptcy? In the case of DBO, an investor would receive their proportionate share of the Light Sweet Crude Oil Futures contract that expires in February of 2018. In the case of OIL, the investor would be a creditor and would receive a payout based upon the ruling of a bankruptcy court.
This leads to the initial pricing formula for ETFs and ETNs:
ETF Price = value of underlying investments
ETN Price = value of underlying index + default risk
The adversarial nature of lender and borrow is important to keep in mind in regards to ETNs. Borrows (issuers of ETNs) want to borrow as cheaply as possible and lenders (the investor) want to charge as much as possible on their money. Owners of ETNs face a conflict of interest that is present between borrowers and lenders. As such, the borrower will act in their best interest first. This includes structuring ETNs to be as favorable to the issuer as possible. One such provision of an ETN that is favorable to the issuer is the call provision. Most ETNs are callable at indicative value with as little as 3 to 5 days notice. This could result in significant loss if the early call or “Acceleration At Our Option” provision is exercised. As of this writing, we are not aware of any ETNs that have exercised this call provision; however, it is important to take this factor into consideration when purchasing an ETN above indicative value.
Share Creation / Redemption Process:
The other difference between ETFs and ETNs is the share creation and redemption process. The creation process for an ETF is quite simple, an investor provides the issuer with the underlying stocks in exchange for shares of the ETF. For example an institutional buyer wants shares of BND, the buyer would then purchase the individual bonds that are in the index, and then deliver them to Vanguard in exchange for shares of the ETF. The redemption process for ETFs is the same but in reverse. For example an institutional seller could go to State Street and request the individual stocks in the S&P 500 in exchange for shares of SPY. The creation and redemption process is open-ended with few restrictions, which is typically the requirement that 50,000 shares are created or redeemed. The creation and redemption of shares is driven by market participants and not necessarily limited by the issuing firm. The creation and redemption process for ETFs facilitates trading in the open market at or near NAV.
The creation and redemption process for ETNs is slightly different. ETNs are typically issued in a fixed amount upon inception. Additional shares of the ETN can be created at the discretion of the issuing firm and not by participants in the market. It is important to keep in mind that ETNs are debt, and the issuing firm maybe unable to issue more shares if the firm has reached an internal debt limit. Redemption of ETNs is similar to ETFs where large blocks of shares, usually 50,000, can be redeemed back to the issuer at the indicative value. The one-sided nature of supply creation can have a material impact on an ETNs market price relative to indicative value. Large institutional traders can remove supply from the market, but cannot add additional shares to the market.
TVIX, the two times short VIX ETN, is an excellent example of the dynamics of the creation and redemption process for ETNs and its effect on market price. TVIX was issued by Credit Suisse in November of 2010 maturing in December of 2030. In February of 2012, Credit Suisse stopped the issuance of new shares, because the size of the ETN hit an internal limit. The market price of the ETN began to trade well above its indicative value. Towards the end of March 2012, Credit Suisse issued a press release stating they would begin reissuance of share of TVIX. The market price of the ETN fell substantially that day causing some investors to lose more than 50%. The large market price premium of TVIX was caused by the lack of supply of shares.
Since the creation of ETN shares is dependent upon the issuer, large market participants are unable to create new shares, which would reduce the market premium. Large institutional buyers through the redemption process have a mechanism that prevents ETN market price from falling below indicative value. If an ETN is trading below its indicative value, an institution could buy shares; redeem them back to the issuer, which reduces the supply of shares in the market which brings market prices up in line with the indicative value. This assumes that there is no credit event that precipitated the decline in market price. This arbitrage mechanism is not available on the creation side of ETNs, which allows for large market premiums to exist if the issuer stops creating shares. If an ETF trades at a premium to NAV, institutional participants will buy the individual underlying securities, deliver them to the ETF provider, and immediately sell the ETF shares in the marketplace to capture a risk-free rate of return. This in turn creates more ETF shares, which then brings the market price in-line with NAV.
Updating our ETF and ETN pricing formula to reflect the creation and redemption process:
ETF Price = value of underlying investments + trading costs to create or redeem shares*
ETN Price = value of underlying index +default risk + supply of shares
*If an ETF is trading at a discount or premium, institutional buyers might not be able to capture the difference between the value of the underlying investments and the market price of the ETF due to trading costs to acquire or sell the underlying investments.*
SPY, the State Street 500 Index ETF, is trading at ~$240 per share. Assuming that the NAV is $239, the ETF is trading at a premium of $1 per share compared to the underlying value of the individual stocks. In this case, an institutional buyer would go into the market and buy the stock of the 500 companies for a total of $239 plus trading costs. Assume trading cost is $0.50. The buyer would then take the individual stocks and exchange them to State Street in exchange for 1 share of SPY. The institutional buyer would then turn around and sell SPY for $240, netting a return of $0.50. This process adds additional supply of SPY to the market, which then reduces the market price to NAV. The opposite would occur if SPY was trading at a discount.
SPY market price = $240
SPY NAV = $241
Buy SPY & redeem in-kind to receive the 500 stocks
Sell individual Stocks in the market = $241
Trading Costs = $0.50
Arbitrage Profit = $0.50
This arbitrage mechanism keeps the market price of ETFs close to NAV plus or minus the cost to trade the underlying securities.
ETFs and ETNs also differ in regards to their tax treatment. The tax treatment of ETFs is known. The tax treatment of ETNs is unknown. The IRS has not made a ruling on the tax treatment of ETNs. In 2016, Congress proposed that ETN holders “mark-to-market” and pay on their paper gains. There is also uncertainty if the ETN holder is subject to IRS code 1256, which codifies taxation of futures contracts. ETNs are a type of pre-paid futures contract. In 2007, the Treasury Department issued a noticed that they would evaluate if ETN holders accrue interest, even though none is paid, and if gains should be treated as ordinary income at the time of sale or early redemption. The tax treatment, when or if it is determined, could substantially impact the after-tax performance of ETNs. ETN prospectuses highlight and bold the uncertain tax treatment of ETNs, and investors should heed this caution and seek the counsel of an accountant or a tax attorney. If there was certainty of taxability, the ETN provides would provide that in their prospectus.
ETFs and ETNs provide investors a simple, inexpensive means of accessing certain segments of the market. Both seek to track an index and both are typically available to purchase directly on an exchange. However, the underlying differences between ETFs and ETNs are important for an investor to understand. The dissimilarities between the two exchange traded products is so great FINRA and the SEC issued alerts to caution investors about this product. These differences, particularly the ownership structure and the creation / redemption process, can have a materially impact on performance. It is important for investors to be able to understand these differences and evaluate them to arrive at an informed decision. Most importantly, the market price of the ETN will be affected by factors beyond the performance of the underlying index. This is not to say that ETNs are an inferior or evil product in comparison to ETFs or mutual funds; rather, it is important to understand the internal-mechanics of ETNs prior to investing.
Know what you own.
Adam Hoffman, CFA, CAIA
For more information on the creation and redemption process of ETFs and the market price differential to NAV, please see:
Petajisto, Antti. (2017, Jan/Feb). “Inefficiencies In The Pricing Of Exchange-Traded Funds”. Financial Analyst Journal, vol. 73, no. 1. Retrieved from CFAInstitute.org
Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.