Looking to diversify your portfolio? Maybe you have heard of exchange-traded funds (ETFs) and exchange-traded notes (ETNs). Both have similar sounding names and both offer instant diversification, but these two investment vehicles are actually extremely different. They both serve the same purpose in your portfolio, but they are structured quite differently. In fact, the structure of ETNs makes them much more risky than ETFs. Let’s take a look at the differences and why you might want to stick with ETFs.

[VIDEO] ETFs or ETNs? Choose Exchange-Traded Funds

Exchange-Traded Funds (ETFs) vs. Exchange-Traded Notes (ETNs)

Exchange-traded funds (ETFs) are one of the most popular investment choices for investors looking to diversify their portfolios. ETFs are investment funds traded on stock-markets. They are not mutual funds yet they offer all of the benefits of diversification that you would expect from a mutual fund. ETFs also enjoy all of the benefits of liquidity that you have from trading individual shares.

ETFs offer instant diversification because when you purchase one, you invest in a fund that buys and holds multiple assets. ETFs are like baskets into which fund managers place various assets such as stocks, bonds and commodities. When you buy an ETF, you buy ownership of a basket and its contents, not piecemeal ownership of the individual contents. That saves substantially on trading costs as well as on the capital you would need to buy each individual stock within an ETF that corresponded to an index, like the S&P 500.

Exchange-traded notes (ETNs), on the other hand, are not investments funds. ETNs are structured products that are issued as debt securities by banks and are based on the performance of various assets, indexes and strategies. When you buy an ETN, instead of putting your money into a fund that actually buys and holds assets, you are buying debt from the ETN issuer—much like a bond investor would. Instead of being backed by the assets that are in the investment fund like ETFs are, ETNs are simply backed by the full faith and credit of the issuer.

ETNs have maturity dates. When you hold an ETN until the maturity date, you receive a one-time payment based on the performance of the underlying asset, index or strategy. For instance, if you buy an ETN covering oil and the value of oil appreciates during the time you are holding the ETN, you will receive a higher payment at maturity than you will if the value of oil depreciates during the time you are holding the ETN.

Of course, you do not have to hold an ETN until maturity if you don’t want to. You can sell your ETN at any time on the open market. However, depending on current market conditions, you may get a less favorable price for your ETN if there are not a lot of interested buyers in the market.

Risks Associated with Exchange-Traded Notes (ETNs)

Exchange-traded notes (ETNs), just like any other investment, carry risk. However, ETNs carry the following two risks that ETFs don’t:

• Credit risk
• Call risk

Credit risk is the risk that the institution that has issued the ETNs will default on the notes. Remember, ETNs are issued as unsecured debt securities—meaning there are not specified assets that serve as collateral for the ETNs. Instead, ETNs are only backed by the full faith and credit of the issuer. In good times, this isn’t typically a problem. But during a financial crisis when banks and other large financial institutions—the main issuers of ETNs—are at risk of collapsing, it can be a big problem.

To illustrate my point, the following is a list of ETN issuers:

• Bear Stearns
• Lehman Brothers
• Morgan Stanley
• UBS
• Barclays Bank
• Goldman Sachs
• Credit Suisse
• BNP Pariba

Any of these names look familiar? If you paid any attention to the news about the Credit Crisis of 2008, you definitely recognize these names. A few of them are not even around anymore.

Call risk is the risk that the issuer of the ETN may call the ETNs back before maturity. If an issuer calls an ETN back, the issuer will compensate you for the ETN according to the call provision in the ETN, but you will lose the right to hold the ETN until maturity.

Image courtesy mckaysavage.