Get Clarity about ETFs, ETNs, and ETPs

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Hardly a week goes by that I don’t hear the question “What are ETFs?”  And not just from novices, either.  Even people who have been investing for decades confess that they too, don’t understand.

If this group includes you, don’t be alarmed.  I’ll let you in on a secret.  Many professional investors also don’t fully grasp the world of Exchange Traded Funds (“ETFs”).

ETFs are just what their name says: funds that trade on a stock exchange.  A simple, easy definition is “mutual funds that trade like a stock.”  This covers the majority of ETFs but there are many exceptions.

To make matters worse, attempts to distinguish the various products just adds to the confusion.  Products like Exchange Traded Notes (“ETNs”) are superficially similar to ETFs, but have very important differences.

 What makes an ETF?

So, what makes an ETF an ETF?  What distinguishes an Exchange-Traded Fund from other investment securities?  The first US-listed ETF, SPDR S&P 500 (SPY), arrived on the scene in 1993 with a number of new features.  Yet in some ways it was quite familiar as well.

• The fact that SPY was a fund consisting of many stocks was nothing new; mutual funds had been around for decades.
• The fact that it tracked the S&P 500 index did not make it unique; the Vanguard 500 (VFINX) was launched in 1976.
• The fact that it was a fund that traded all day on a stock exchange was also nothing new; closed-end funds had also been around for decades.

So what made SPY so special?  What set it apart from everything else?  Two major features combined to form today’s thriving ETF industry.

1. First, SPY had an Intraday Indicative Value (IIV), sometimes just called the Indicative Value, Underlying Trading Value, or Net Asset Value (NAV).  Additionally, this IIV was updated every fifteen seconds while the market was open.  For this to be possible, the fund’s holdings have to be 100% transparent.  The actual value of the underlying portfolio can be updated only if the actual holdings are fully disclosed.
2. Second, the first ETF had the ability to create new shares and redeem existing shares through an in-kind exchange process.  Since the holdings were known, large institutional investors (called Authorized Participants) could assemble baskets of stocks that exactly duplicated the ETF’s holdings and exchange them for ETF shares (and vice versa).

Now, these two things may not sound like a big deal, but they are.  They are the essence of what makes an ETF an ETF.  The IIV means that traders can determine if the ETF is trading at a fair price any time the market is open.  The in-kind exchange process means that the trading price should track the IIV very closely.

This arbitration mechanism distinguishes ETFs from closed-end mutual funds.  If an ETF starts trading at a discount to its NAV, the Authorized Participants have a profit opportunity.  They can step in and buy the ETF on the open market, do an in-kind redemption to receive the underlying shares, and then sell the stock, making a profit on the difference.  The Authorized Participants can (and will) repeat this process until the discount disappears.

If the ETF trades at a premium to the IIV, the opposite happens: an Authorized Participant exchanges the underlying stock for ETF shares and then sells the ETF at a premium, making a profit on the difference.

This mechanism brings another benefit for all shareholders: in-kind exchanges (and therefore Creations/Redemptions) are not taxable events.  Supply and demand imbalances can be resolved without hurting existing shareholders.  This eliminates a significant source of investor dissatisfaction with traditional open-end mutual funds.

 Differences With Other Products

Traditional open-end mutual funds are not ETFs.  While they can create and redeem new shares and have ticker symbols, you cannot buy or sell them during the day.  They are only priced once, when the market closes.

Closed-End Funds (“CEFs”) are not ETFs because they lack the ability to create or redeem shares.  As a result, their market price often reflects a large premium or discount to the fund’s NAV.

Exchange Traded Notes (“ETNs”) are often lumped in with ETFs.  They also have an IIV and the ability to create and redeem new shares.  However, there is a very important difference: as a “fund” an ETF is a separate entity that directly owns the securities in its portfolio.  As such, shareholders do not stand to lose if the sponsor or portfolio manager declares bankruptcy.

Conversely, an ETN is not a unique entity, it is simply an unsecured debt obligation (“bond”) issued by a large investment bank.  The ETN promises to track the performance of an index, but it doesn't directly own the underlying securities.  Because of this, it carries the credit risk of the issuing bank.  ETN investors are at risk if the bank should go bankrupt or otherwise default on the notes.

Some ETFs and ETNs focus on commodities, creating another segment sometimes called Exchange Traded Commodities (“ETCs”).  This name has not caught on yet and may never become commonplace.  The important thing to understand about commodity ETFs is that some implement their strategies with futures contracts while others directly own (“physically backed”) the underlying commodity, like gold.

Sometimes it’s important to make the distinction between ETFs and ETNs.  Other times it’s not.  This gives us yet another name: Exchange Traded Products (“ETPs”), which is handy when you want to refer to both groups.

So, whether we are talking about ETFs, ETNs, or both, what sets them apart from other investment vehicles is the Intraday Indicative Value and share creation/redemption through in-kind (and/or cash) exchanges.  Combined, these two simple concepts become a powerful force.

Your ETF Expert,

Ron Rowland

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