So typically we will use the term "ETF" when doing our update or in these educational articles. Sometimes investors will describe it to mean a lot of things that aren't technically "exchange-traded funds". In truth many of the products that people call an ETF, such as commodity pools, trusts and debt securities, aren't actually ETF's at all. Honestly, I am guilty of this too. When we do our ETF update there are many products that we label as ETF's but in fact aren't really. This is not to mislead you, its just how the industry uses the term loosely.
Today we will look to clarify this as we explain what is the most important of these structures to understand... the exchange-traded note, or simply ETN.
ETNs are actually debt notes issued by a bank. When you buy an ETN, the deal is that the bank promises to pay you a certain pattern of return. If you buy an ETN that is linked to the price of gold, for instance, the value of that specific ETN will increase if the gold price goes up.
The reason the product creators love the ETN structure is that it can be linked to anything. There are ETNs that track commodities, and ETNs that track hard-to-reach corners of the equity market. They sometimes combine stock or bond positions with options overlays, or use other sophisticated strategies that would be difficult to package into a traditional ETF. Speaking specifically about the commodity space, the ETN also offers significant long-term tax advantages compared with most ETFs.
The downside of an ETN, and its a big one, is that if the underlying bank goes bankrupt, you lose essentially all of your money. A good example takes us back to only 2008 where a few ETNs backed by Lehman Brothers went under with the bank. While most investors in Lehman's ETNs fled before the firm shut down, anyone who held to the bitter end probably still has a bad taste in their mouth.
The good news is that this credit risk in most situations is very minor. Institutional investors can "redeem" (or get their money back) from the underwriter of an ETN on a daily basis, just like stock, or an ETF. While anything can happen, you can usually see major bank defaults coming more than a day or two ahead of time.
The even-better news is that credit risk is easily monitored. There are many great sites and analysts that monitor and report on the credit risk of every ETN on a daily basis.
So the bottom line is that traders and investors will usually just describe a product as an ETF, but if you see it come up as an ETN no you know why.