ETF vs. ETN vs. ETP – Differences, Similarities, Risks, Etc.

ETF. ETN. ETP. So many initialisms. Here we'll explore what these things are and what differences exist among them.

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ETF vs. ETN vs. ETP – What Do the Letters Mean?

First, here's what these initialisms stand for:

ETF – Exchange Traded Fund
ETN – Exchange Traded Note
ETP – Exchange Traded Product

Secondly, I created this crude Venn diagram to illustrate the relationship among them:

Basically, ETP describes all exchange-traded products, which includes ETFs and ETNs. So ETFs and ETNs are just two types of ETPs. Put another way, all ETFs are ETPs, but not all ETPs are ETFs. Say that 5 times fast.

ETF vs. ETN – Comparison Table

Before we get into the details, here's a quick, broad comparison table for ETF's vs. ETN's:

ETF vs. ETN – Similarities, Differences, and Risks

You've probably heard of ETFs. They're very popular. They almost always track some index (index funds), such as the famous S&P 500. ETFs are an alternative to mutual funds, and are quickly replacing mutual funds. In buying an ETF, you're buying a fund that holds the assets from the index it tracks. As the name suggests, ETFs trade on exchanges just like stocks.

ETNs are less prevalent and less popular. They are a relatively new product; they were first created in 2006. Like ETFs, ETNs trade on an exchange, track some index, and usually have lower fees than an actively managed fund. Unlike ETFs, however, ETNs are unsecured debt instruments. You can remember this if you think of the word “note” as a piece of paper.

Think of an ETN like a corporate bond. This means the ETN is issued by some institution, which carries what we call counterparty risk. This is the main difference between ETFs and ETNs that investors pay attention to. Essentially, if the issuer of the ETN goes under, there's a chance you could lose all the money you put into it, whereas with an ETF, the shares would simply be liquidated at their market value.

With the ETF, you still own the underlying assets. With the ETN, there are no assets. Also, since ETNs are less popular, there may be liquidity risk as well; all things being equal, an ETF will likely be easier to sell than an ETN.

ETNs also typically have what are called mandatory acceleration triggers. Many ETNs – particularly leveraged and inverse ones – include clauses that force early termination if the indicative value drops below a specified threshold (often 80% in a single day). This feature destroyed XIV holders in 2018.

ETNs do arguably have some advantages, though. They don't buy or sell any underlying assets like ETFs do and they don't have dividends or distributions, so there are no taxes or trading costs associated. The investor only incurs taxes upon selling the ETN. Moreover, since an ETN doesn't hold the assets, it doesn't have tracking error like ETFs do. Tracking error means the difference in price movement between the ETF and its index.

With ETNs, you're basically trading some tracking and tax advantages for complexity, callability, and counterparty risk.

You may run into an asset – like gold, for example – where only ETNs are available. ETNs are commonly seen for things like commodities and currencies that are harder for retail investors to buy directly. This is why they were invented in the first place.

Just know that in buying an ETN, you are taking on extra counterparty risk in that you are subject to the credit rating of the issuer, so while it's rare, there exists a non-zero probability of default, meaning you're almost certainly losing at least some of your money. I'll cover a couple examples of this below. Always check out the trading volume of an ETN and the credit rating of its issuer before buying one.

As you can see, ETNs are a bit more complicated than ETFs. ETFs are easier to understand. Simplicity in portfolios is extremely valuable, particularly for new investors, so you should probably usually stick with ETFs whenever possible. Basically, only buy an ETN if it is the only product available for the asset you want.

ETN Case Studies

I hinted at some risks of ETNs. They probably sound trivial, but they're not. While these events are rare, here are a couple salient examples of when the ETN structure meant trouble.

Lehman Brothers – 2008

When Lehman Brothers filed for bankruptcy 2008, they had 3 outstanding ETNs for which the combined AUM was around $15 million. The holders of those notes became unsecured creditors in the bankruptcy proceedings. Senior unsecured Lehman creditors ultimately recovered somewhere around 30-40 cents on the dollar, spread over years of proceedings.

This is the textbook worst case scenario – The ETN issuer fails, and you're not getting your money back, at least not all of it and not quickly. The underlying index could be up 50% and it wouldn't matter. You own a note, not assets, meaning you're at the mercy of the court proceedings.

It's also the only major example of this happening with a US-listed ETN. Again, low probability event, but pretty catastrophic if/when it does happen.

XIV – 2018

Probably the most dramatic ETN implosion in history didn't require the issuer to fail; it was simply the product of some fine print in the prospectus.

Credit Suisse launched XIV, the VelocityShares Daily Inverse VIX Short-Term ETN, in late 2010. It delivered -1x the daily return of the VIX futures index. In calm markets, volatility is elevated relative to realized volatility, so selling volatility via XIV made for small steady gains, and it became a popular trade. By January 2018, XIV had accumulated roughly $2 billion in assets.

On February 5, 2018, markets dropped sharply. The S&P 500 fell about 4%. VIX futures, which had been unusually compressed, exploded higher, meaning XIV fell sharply. By the close and into after-hours trading, the VIX had more than doubled, the largest single-day spike on record at that time. XIV's indicative value collapsed roughly 96% in a single session.

That's when the aforementioned fine print kicked in. XIV's prospectus included an “Acceleration upon Acceleration Event” clause that said if the ETN's indicative value fell 80% or more from the prior day's close on an intraday basis, Credit Suisse could terminate the product early. So the next day on February 6, Credit Suisse announced XIV would be accelerated, with a final settlement date of February 21, 2018. Holders received roughly $6 per ETN, down from a prior close above $108.

The comparable product on the ETF side was SVXY, the ProShares Short VIX Short-Term Futures ETF. It also lost about 90% that day, but it was not accelerated, as ETFs don't have acceleration clauses. ProShares subsequently restructured SVXY to target -0.5x instead of -1x exposure, but SVXY survived and still trades today while XIV closed.

Nearly $2 billion of market cap was erased essentially overnight. Class action lawsuits against Credit Suisse were mostly unsuccessful. Courts found the acceleration clause had been adequately disclosed in the prospectus.

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