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ETN - Exchange-Traded Note

ETNs, or exchange-traded notes, are essentially unsecured promissory obligations issued with the backing of a financial institution.

These "notes," which can be thought of as bond issuances, guarantee investors the return on a given index (thus, they will not produce any tracking error) and have stated maturity dates (though, like stocks or ETFs, they can be bought and sold throughout the day in the interim for those who don't plan to hold to maturity).

ETNs' unique structure allows ETN providers to replicate asset-allocation strategies and gain access to asset classes such as commodities, foreign markets, and currencies that may otherwise be difficult to access via other investment vehicles. However, because they are essentially promissory obligations, ETNs carry the credit risk associated with the backing financial institution. 

ETFs (exchange-traded funds), on the other hand, have an underlying portfolio containing the securities in the index that they track and are not subject to any credit risk associated with the ETF provider. If an ETF provider were to go out of business, the investors in its funds would still have claim to the funds' underlying portfolio securities or the market value of those securities in the case that the ETFs are liquidated.

Despite the lack of tracking error that ETNs enjoy, we think it is a good practice to monitor whether the market price of a given ETN trades at a discount to its indicative NAV. This would be a "red flag" indication of the market's nervousness related to the issuer's creditworthiness. In the end, to fully grasp the extent of the credit risk associated with a given ETN, investors should lean on a stronger fundamental analysis of the bank, rather than potential discounts in the market price versus the NAV.

For risk averse investors who are unwilling to assume the credit risk and potential loss of their investment--regardless of how low the probability of default may be--we think avoiding the structure altogether could be a prudent and sensible choice.

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