What Separates an ETF from an ETN

Commodities have been one of the hottest investments to own in 2007. So it's no surprise that commodity-based exchange traded funds (ETFs) have been at the top of the charts in performance this year. Recently, Barclay's Bank launched a new series of commodity tracking fund know as Exchange Traded Notes (ETNs).

Before you jump into some of these new investment vehicles looking for repeat performance in 2008, it's important you understand the similarities and differences between ETFs and ETNs.

First off, ETN shares DO NOT represent fractional ownership of the fund’s underlying assets. By contrast, ETFs DO allow you to hold fractional ownership. For example, the iShares Dow Jones U.S. Energy Sector ETF (symbol: IYE) holds shares of Exxon Mobile in its portfolio. So if you own IYE, you are in essence a fractional owner of Exxon.

In fact, ETFs are structured in such a way that if you own enough shares of IYE (we’re talking very large numbers of shares) you can actually contact Barclays and ask them to redeem your IYE position for individual shares in all of the portfolio’s underlying stocks. Big institutional investors do this all the time. That’s how ETF prices stays so close to the underlying net asset value of its holdings (unlike closed-end funds).

Instead of offering partial ownership of a fund’s portfolio, Barclays ETNs are debt securities. So a Barclay’s ETN is essentially a bond issued by Barclays Bank. However, you don’t receive a fixed return like a bond does. Instead,  your ETN is linked to the performance of the underlying index, minus Barclays’ management fees of course.

ETNs Have a Shorter Life Span and Face Potential Credit Risks

Also ETFs have an indefinite life span, whereas ETNs have a stated maturity date (just like bonds), usually of around 30 years. If you’re the type of investor who plays a market trend over a period of 6 -months to a year or more, then ETNs maturity date isn’t really a big deal.

ETNs also involve more risk than ETFs. Not only are you assuming market risk (there’s always a chance that the underlying index may go up or down), you are also assuming credit risk by owning an ETN. It’s just like owning any other bond.

In other words: Will Barclays pay up when your ETN matures? Frankly, it’s not that big of a concern with large, A-rated banks like Barclays. These banks have reputations to protect, so they’re likely to stand behind their ETNs. But still,  you should be aware that it is a “potential” added risk to owning an ETN.

Now that you know the ins and outs of ETNs, tune into my blog tomorrow to find out about some of the most interesting new ETNs targeting specific commodity sectors that might be worth watching in 2008.