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ETFs vs. ETNs: A Guide to Exchange Traded Products

November 2, 2021

Christina

ETFs vs. ETNs: A Guide to Exchange Traded Products
Over recent weeks, Bitcoin ETFs have been headline news and caused prices to reach new all-time highs. But ETNs are coming soon, and are they better than ETFs?

What’s more, events have ignited debate from across the financial spectrum regarding what types of products may come next, including other variations on exchange-traded products. As such, it’s worth understanding some of the key terms being used and what they mean for market participants. 

Exchange-traded Products 

The term “exchange-traded products” or ETPs is an umbrella term used to describe a group of products, which includes exchange-traded funds (ETFs) and exchange-traded notes (ETNs). The underlying principle is that ETPs track the value of an underlying asset, such as a security, commodity, or index.

However, despite their similarities as tracking instruments, ETFs and ETNs have some key differences. 

What Is an Exchange-Traded Fund (ETF)? 

Exchange-traded funds or ETFs operate in a similar way to a mutual fund. The critical difference is that while a mutual fund manager chooses the investments in the fund’s portfolio, an ETF automatically selects investments based on the underlying index, sector, or commodity profile. 

Typically, an ETF tracking an index (like the S&P 500 or the FTSE 100) will own a portfolio of all the stocks that make up the index. ETFs became popular due to their low fees, as, unlike mutual funds, they’re passively managed. 

However, some ETFs don’t necessarily hold the underlying asset but may hold a combination of derivative products that offer similar exposure. For example, the recently launched ProShares Bitcoin Strategy ETF tracks the prices of Bitcoin futures contracts traded on the CME. Similarly, many ETFs based on commodities that are difficult to store, such as oil, are based on futures contracts rather than the physical asset. 

The Contango Risks of Futures ETFs

Futures ETFs have some particular added complexities for investors. Contango is a phenomenon in the futures markets where the price of a futures contract is higher than the underlying product’s price in the spot markets. It can occur more often in newly-issued contracts, as prices tend to converge once a futures contract expires. 

However, this phenomenon has implications for ETFs based on futures contracts. The ETF will always need to continually top up its portfolio with new contracts as the old ones expire. Ultimately, contango creates the risk that ETF investors lose profit due to the ongoing threat that the ETF is paying a premium for futures contracts with a longer expiry date. 

Issues like this led to some criticism of the new Bitcoin ETF when it launched in late October. While a physically-backed ETF, such as the one proposed by Grayscale, could provide a compromise, the SEC’s position on physically-backed Bitcoin ETF currently makes an approval seem unlikely. 

What Is an Exchange-Traded Note (ETN)?

Unlike an ETF, an exchange-traded note, or ETN, doesn’t have any actual stocks or derivatives underlying it. Instead, an ETN is a debt security issued by a bank. It tracks the value of the underlying index or assets via a promise to pay its full value upon the ETN maturity. 

In this respect, it’s more like a bond than a stock instrument. The holder must trust that the issuer will make good on its debt when the ETN reaches its expiry date.  

While the credit risk element is a drawback for many people, ETNs hold some distinct advantages over ETFs. ETNs offer tax benefits compared to stock-tracking ETFs, which usually pay dividends subject to capital gains tax. Because ETNs don’t have any underlying stocks, there are no dividends payable, so profits only become realized when the ETN matures and is paid out. 

ETNs also avoid the risk of tracking errors that’s inherent in ETFs. ETFs intend to mirror an index by owning shares in the underlying, but the actual performance may vary, which is known as a “tracking error.” An ETN avoids such errors, as it’s treated as a pre-agreed contractual payment. 

Bitcoin ETFs vs. ETNs

Banks have historically used ETNs to offer investors access to more exotic products that aren’t tracked via more traditional ETFs. However, in light of recent developments in Bitcoin ETFs, it seems plausible, or even likely, that we could see further evolution in the Bitcoin ETN space too. 

If a physically-backed ETF seems like an unlikely proposition for regulatory approval, then an ETN may be a more attractive idea. After all, the logic that an ETN is a pre-paid contract tracking an index also means that a Bitcoin ETN could avoid the contango risks faced by a Bitcoin Futures ETF. 

Although it arrived with less fanfare than the recent Bitcoin ETFs, in August, derivatives exchange Eurex announced it was due to launch the first regulated market in Bitcoin ETNs in Europe. So there is form, and it seems likely we can expect ETNs to emerge in the cryptocurrency markets more prominently, sooner rather than later. 

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