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ETFs v. ETNs: Part 1: A focus on The ETF

Both ETFs (exchange traded funds) and ETNs (exchange traded notes have been making a lot of noise lately.  Morningstar Inc. now tracks 89 ETNs with $7.3 billion in assets and 732 ETFs with $586 billion in assets.  Both seem to be similar and are used by individual investors and institutions alike for many different strategies.  However, I think there is a little confusion about the uses, risks, and basics of these two investment vehicles

Today let's start with ETFs

1.  An ETF (exchange traded fund) is a rule based fund that tracks a designated index.  

2.  ETFs are uniquely created and unlike a mutual fund.  See Diagram below for a visual of how a ETF is created.

Click Here to Enlarge Diagram

3. ETFs trade like stocks and can be shorted (on the down-tick)

4.  Since ETFs trade at market prices and not NAV (Net Asset Value, the combined weighted prices of the stocks in the index), Market Makers can "unmake" and ETF through the fund advisor into a creation unit (the basket of stocks).  The reverse of what is pictured above.  It is done in a way that has zero tax consequences and called "in-kind" transfer.

This ability to unmake an ETF into a basket of stocks could created an arbitrage opportunity.  Therefore Prices stay very close to NAV.

In the same way, if an ETF fund advisor goes belly up the basket of securities that make up the ETF are liquidated and paid out to the holders of the ETF.  So there is no loss of principal when an issuing firm files bankruptcy.  However, this may create very unfavorable tax consequences for some investors in taxable accounts.

5.  An ETF can be created to track any rule based index such as a sectors, style, market cap, option strategy, and special attributes such as dividends or "green companies" .

In Part 2 I will go through the world of ETNs.  Also in the future I will continue to discuss the world of ETFs and the strategies that investors use with them.

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