With some volatility exchange-traded products (ETPs) getting crushed recently, I think beginning traders need to understand the differences between exchange-traded funds (ETFs) and exchange-traded notes (ETNs). There’s one thing our community practices: trade what we know. If you don’t know why ETFs and ETNs differ, you shouldn’t be trading them. However, ETFs and ETNs offer lucrative opportunities. That said, let’s take a look at some key differences between ETFs and ETNs.
Exchange-Traded Funds (ETFs) Explained
An exchange-traded fund (ETF) is similar to a mutual fund. ETFs offer a proportionate share in a portfolio of securities. However, ETFs trade throughout the day on various exchanges and market participants determine the price, similar to stocks. Now, an ETF tracks an underlying asset, which could be an index, a commodity, bonds or a portfolio of assets. If you’re long an ETF, you’re entitled to a portion of dividends and interest. Additionally, you could also receive a residual value in the event the fund is liquidated. Depending on the ETF, there are various risks and you should always refer to the fund’s prospectus and website to get an idea of how the product trades.
For example, the iShares Nasdaq Biotechnology ETF (IBB) is an ETF that provides exposure to U.S. biotech and pharma companies. IBB aims to track the performance of the Nasdaq Biotechnology Index, the fund’s underlying, or benchmark, index. Generally, IBB’s percentage performance is more or less the same as the Nasdaq Biotechnology Index’s percentage changes.
Here’s a look at the IBB’s and its underlying index’s performances:
Notice how the charts are nearly identical. This is typically what you see when you invest in or trade ETFs with an underlying index.
Exchange-Traded Notes (ETNs) Defined
ETNs are structured products issued as senior debt notes. That in mind, ETNs are more like bonds, while ETFs are more like stocks. ETNs carry a high degree of risk, and some ETNs may decide to liquidate funds at any point. Additionally, ETNs have credit risk. For example, if you are long an ETN and the issuer goes bankrupt, you’re pretty much at the end of the line to get your redemption value. The creditors have to get their money first. Since ETNs carry credit risk, credit ratings could affect an ETN’s price.
For example, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) holds a portfolio of a mixture of CBOE Short-Term VIX Future contracts expiring on two different dates, the front month and back month. This product aims to provide traders with “short” exposure to volatility. Therefore, when volatility explodes, XIV depreciates quickly. This happened when the CBOE Volatility Index (VIX) soared over 100% in just a matter of days. In turn, XIV lost over 80% of its value in the post market one day, which triggered an acceleration event. Credit Suisse, the issuer of XIV, announced a plan to liquidate the ETN.
Here’s a look at XIV and the VIX:
XIV crushed longs in this trade. This is a highly dangerous product, especially if you haven’t read through the prospectus before buying the ETN. If you got long at 100, thinking volatility would come in, well…you would’ve had a rude awakening. There’s a time and place to short volatility, and this wasn’t it.
ETNs and ETFs are different products and you should keep in mind the differences between the two. Generally, only highly risk tolerant individuals may consider trading ETNs. There’s one thing in common with exchange-traded products: you should always understand the product’s inherent details. All you need to do is read a summary prospectus, fact sheet and the exchange-traded product’s website. I don’t suggest anyone go into these trades blindly. If you just bought XIV blindly, you could’ve lost a fortune. Bottom line: trade what you know.
Kyle Dennis runs Kyle Dennis’ Biotech Breakouts (biotechbreakouts.com). He is an event-based trader, who prefers low-priced and small-cap biotech stocks.