An investor's guide to ETFs and ETNs: A comparative study (Part 3 of 6)
There are certain aspects where an ETF scores over an ETN.
The credit rating of the issuer is an important metric that needs to be researched when investing in ETNs. Various credit rating agencies rate corporate firms on the basis of the credit risk associated with them.
Companies with high-grade to lower medium-grade ratings (as can be seen in chart above) have negligible risk of defaulting on their obligations vis-à-vis those with non-investment grade to extremely speculative grade ratings.
When investing in ETNs, the biggest risk is the credit risk. Credit risk is the risk that the issuing bank may default on the ETN. ETNs are unsecured, unsubordinated, and take on the credit risk of the issuing bank. Because ETNs are a debt, they have a maturity date—usually about 30 years after the issuing date—when the note’s principal is paid out to the investors. But, if the issuing firm, such as UBS or JP Morgan, were to go bankrupt, investors may not receive their full investment back, if anything at all.
An issuing bank’s high credit rating does not make it infallible. Although ETNs are issued by major top-rated banks, if their credit ratings are cut, they will affect the ETN negatively, regardless of the underlying market move. So, if the issuing bank loses credit rating, the ETN can default. Big financial institutions have tumbled in the past. Lehman Brothers had issued three ETNs at the time of its bankruptcy in September 2008. So, the risk is quite real.
ETFs, on the other hand, operate in perpetuity. If an issuer of ETFs, such as iShares or PowerShares, goes belly up, an investor’s capital is safe and secure. So, an investment in the iShares Core S&P 500 ETF, with holdings in Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM), or in the PowerShares Senior Loan Portfolio (Fund) (BKLN), or iShares Core Total U.S. Bond Market ETF does not entail credit risk.
With ETFs, liquidity should not be a key concern as substantiated by our analyst Dale A. Norton in his article, Why ETF liquidity should not be a key concern.
With ETNs, liquidity is an associated risk. Currently, there are a lot more ETFs in the investing world than ETNs. That means trading in and out of ETN positions may not be as easy. Closing or opening an ETN, may be difficult due to lack of trading volume.
Browse this series on Market Realist: