Deciphering the Alphabet Soup of ETFs, ETNs, and ETCs

When it comes to ETPs, or exchange-traded products, investors need to be aware of whether they are buying an ETF, ETN, or ETC. While there are some similarities between the products, with all of them being exchange-traded and most tracking some sort of index, each provides a different set of risks which the investor must take into consideration.

ETFs

ETFs, or exchange-traded funds, are the most well-known structure of the set. Most ETFs are passive, meaning they track an index like the S&P 500, but active ETFs are becoming more popular. 

When you buy an ETF, you are buying shares of a fund that holds assets in the underlying components of the index such as stocks or bonds. Some ETFs can also include derivatives or other ETFs, but the same is still true in that owning shares of an ETF means that you own a slice of the underlying basket of assets.

ETNs

ETNs, or exchange-traded notes, are unsecured debt instruments. Rather than offering exposure to the underlying basket of assets, ETNs are issued by an institution and rely on derivatives to provide the return of the index tracked by the ETN. This fund structure is more common for areas of the market such as commodities and currencies.

ETCs 

ETCs, or exchange-traded commodities, are debt instruments that track the performance of a single commodity or basket of commodities. The term is most commonly used in Europe and Australia.

Different Products, Different Risks

While all of these products are exposed to market risk and the price movements of the underlying assets, ETNs and ETCs are also exposed to counterparty risk of the issuer. While these types of products are typically issued by large, well-funded institutions, this is still no guarantee of the issuer’s ability to pay.

If the issuer of the ETN does go bankrupt, the investor risks losing their investment. While this situation is unlikely, it has happened before. In 2008, Lehman Brothers declared bankruptcy just seven months after launching three ETNs. Days after filing for bankruptcy, trading in these ETNs was suspended, meaning investors were no longer able to sell their shares.  
Along with this counterparty risk, ETNs and ETCs also tend to have higher liquidity risk relative to ETFs. This means that they can have higher bid-ask spreads and are more likely to trade at a premium or discount, potentially eating into returns. Investors should consider typical trading volume and spreads for these products before entering a position.

Different Benefits Too

In exchange for these additional risks, ETNs and ETCs do provide some benefit. Since they are a promise by the issuer to pay the return of the index, there is no tracking error like there would be with an ETF. Buyers of an ETN or ETC can expect to receive the underlying return less the expense ratio.

Another benefit of these structures is that they can be linked to areas that are harder to reach within the ETF structure, which explains why they are most prevalent within the commodity and currency asset classes. Since it is not required to hold the underlying assets, it removes the associated costs.

ETNs can also provide some tax benefits relative to ETFs. ETNs do not pay dividends or interest income, which means that investors within these types of products are only subject to capital gains tax when they sell their investment.  However, there are some exceptions to this rule, as is the case with currency ETNs in the United States. 

Different Tools

As outlined in this article, each structure comes with its own set of benefits and risks. As part of their due diligence, investors should carefully consider the pros and cons of each fund structure when evaluating whether a specific investment is right for their portfolio.

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.