ETFs, ETNs and mutual funds

Owning a portfolio against holding an IOU

An exchange-traded fund is an investment company that holds a portfolio, usually one tracking an index. Its shares list on an exchange and trade all day at prices set by the market, so an investor can buy at eleven and sell at two. A creation and redemption mechanism run by large institutions keeps the market price close to the value of the underlying holdings, which is why an exchange-traded fund rarely drifts to the discounts a closed-end fund can reach.

An exchange-traded note is not a fund at all. It is an unsecured debt security issued by a bank or other financial institution, promising a return linked to an index. There is no portfolio behind it. The holder owns a promise, and the value of that promise depends on the issuing bank being able to keep it. That is credit risk, and it is the one risk an exchange-traded note carries that an exchange-traded fund does not.

A mutual fund sits at the other end on trading. Its shares are not listed, so there is no intraday price at all; every order is filled at the next net asset value computed after the order is received. That single daily price is not a defect, but it does mean an investor cannot react to news during the session and cannot place a limit order on the fund.

Two questions separate all three. Does the investor own a share of a portfolio, or a claim against an issuer? And when is the price set — continuously, or once a day after the close? An exchange-traded fund owns and trades all day; an exchange-traded note is a claim and trades all day; a mutual fund owns and prices once.

Leveraged and inverse exchange-traded funds are a third thing again, and the SEC has issued a bulletin about them because investors misread what they promise. A leveraged fund seeks a multiple of the daily performance of its index, so a 2x fund seeks double what the index does that day. An inverse fund, also called a short fund, seeks the opposite of the index’s daily performance; a leveraged inverse or ultra short fund seeks a multiple of that opposite. They reach those objectives through swaps, futures and other derivatives rather than by holding the index.

The word doing the work in every one of those sentences is “daily”. Most of these funds reset each day, so the objective is renewed each morning and nothing is promised about a week, a month or a year. Performance over a longer period can differ significantly from the stated multiple of the index over the same period, and the effect is magnified in volatile markets, which is how a fund can lose money over a stretch in which its index finished higher. A question describing a buy-and-hold investor in a 2x fund is testing exactly this, and the answer is never simply twice the index return.

Cost is part of the comparison too. A fund’s expense ratio is the percentage of its average net assets used each year to pay operating expenses, such as management fees and distribution fees, and it is shown in the prospectus fee table. An ETF has one too. Because ETF shares trade on an exchange, investors also buy and sell them at market prices plus or minus any applicable fees and charges, and the market price can be higher or lower than the fund’s net asset value. An index-tracking fund usually trades less and carries lower fees and expenses than an actively managed fund, and over time higher fees and expenses can significantly lower returns.

Exam terms

Exchange-traded fund

A listed investment company holding a portfolio, usually tracking an index.

Exchange-traded note

An unsecured note from a bank or other financial institution paying an index-linked return; no portfolio behind it.

Credit risk

The risk that an issuer fails to pay what it promised.

Intraday trading

Buying and selling at market prices throughout the session.

Tracking

Following the return of a stated index rather than picking holdings.

Creation and redemption

The institutional mechanism that keeps an ETF price near its portfolio value.

Worked example

Two investors want the return of the same commodity index. One buys an exchange-traded fund holding the index constituents; the other buys an exchange-traded note from a bank that promises the index return.

1. While the bank is healthy, the two positions behave almost identically, which is why the difference is so easy to miss on a good day.
2. Both can be sold at any point during the session at a market price, and both can be entered with a limit order, unlike a mutual fund tracking the same index.
3. Now the bank is downgraded. The note’s price falls even though the index has not moved, because the market is repricing the chance that the promise will be kept.
4. The fund does not move on that news at all. Its value comes from the securities it actually holds, and the bank has nothing to do with them.
5. If the bank then fails, the note holder becomes an unsecured creditor and joins a queue; the fund holder still owns a proportional share of a real portfolio.

Check yourself

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Related practice

• Exchange-traded product structuresPractice this