Exchange-Traded Funds and Notes

ETFs

An Exchange-Traded Fund (or ETF) is a security that tracks an index (ie the S&P 500), a commodity (ie gold or oil), a sector (ie technology or pharmaceuticals), or even bonds (ie high grade commercial).

ETFs have been available for over 25 years, but have become fashionable over the last few years. There are currently over 4,000 ETFs on the market. When purchasing an ETF, you are buying shares of a portfolio that tracks the yield and return of its underlying index. ETFs don’t attempt to outperform the underlying index, they merely attempt replicate its performance. An index is typically a portfolio of related stocks such as the Dow, NASDAQ Composite, or S&P 500. Many ETFs are based on indexes of market sectors, such as technology, industrials, energy, healthcare, financials, foreign markets as well as market capitalization brackets such as small-, mid-, large-, and mega-cap.

Unlike a mutual fund, ETFs trade like common stock and may be bought and sold throughout the trading day. They typically have higher liquidity and lower fees than mutual fund shares. ETFs combine the flexibility of investing in a diversified portfolio with the simplicity of trading a single equity. ETFs may be purchased on margin, sold short, or held for the long-term capital gain.

ETFs are passively managed, and the fund manager makes only periodic adjustments to keep the fund in line with its index. As a result, they incur lower administrative costs than mutual funds which are actively managed. ETF fees are typically around .2% per year, versus mutual funds may incur as much as 1% yearly cost. There are also possible tax advantages in owning an ETF over a mutual fund. Taxation on cash flows generated by the ETF for selling individual securities to balance the index are not passed through to shareholders as they typically are within mutual funds.

ETNs

Exchange-traded notes (ETNs) are very different from ETFs, although both are in the same family of Exchange Traded Products.

An important feature of ETFs and mutual funds is that they are legally separate from the company that manages them. If the company managing the ETF goes out of business, investors will still own the assets held by the ETF. Different than an independent portfolio of securities, an ETN is a bond issued by a financial institution. The issuing company promises to pay ETN holders the return on some index over a certain period of time and return the principal of the investment at maturity. Similar to Bonds, ETNs trade at discounts and premiums.

There are multiple risks to be considered when purchasing an ETN, including:

  • Credit risk -- the credit worthiness of the issuer (similar to unsecured bonds)
  • Liquidity risk -- ETNs typically have much lower trading activity than ETFs and bid-ask spreads can be large
  • Issuance risk --- volatile premiums can occur as the supply of ETNs are controlled entirely by their issuers
  • Closure risk – since an ETN is a bond issued by an institution, it may also close an ETN due to default, early assignment or even bankruptcy

Before investing in an ETN, it is advisable to research the credit rating and fundamental financial stability of the issuer.

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