Overview of Exchange-Traded Notes

Exchange-traded notes (ETNs) are similar to traditional exchange-traded funds (ETFs), but the differences are very important. Unlike ETFs, ETNs are not funds; that is, they do not hold securities or other assets in trust for their shareholders. Rather, ETNs are unsecured promissory obligations issued with the backing of a financial institution. Essentially, they are bonds.

How they work

Like bonds, they have a stated maturity date, although (like ETFs) they can be bought and sold throughout any trading day for investors who don't plan to hold them to maturity. But instead of paying a stated rate of interest like most bonds, ETNs promise (but cannot guarantee) investors the return on a given index less accumulated fees. There are trade-offs between ETFs and ETNs: ETNs can greatly reduce index-tracking error for more difficult-to-access asset classes, but the potentially improved tracking error comes at the cost of introducing the credit risk associated with the backing financial institution.

How they are similar to ETFs

Let's take a quick look at the similarities between the two products. Obviously, both ETNs and ETFs trade on exchanges just like stocks. But they can also be sold short and may even have options written on them, like stocks. Both ETNs and ETFs track the performance of a specific index, which can cover any area of the capital markets from equities to bonds to exotic exposures like volatility. Crucially, authorized participants (APs) can create and redeem shares of both products with the issuer for the net asset value (NAV) of the underlying index, which creates the daily arbitrage opportunities that can keep their share price trading without a premium or discount to NAV. Finally, ETNs and ETFs both charge fees that are deducted from returns. It is important to note that some ETNs may have path-dependent fee structures that may result in actual expenses that may be greater than (or less than) the product's stated expense ratio depending on the performance of the note's underlying benchmark. Additionally, some ETNs levy ancillary fees that are incremental to their headline expense ratio.