What Is An ETN?

The most important of these structures to understand is the exchange-traded note (ETN).

ETNs are debt notes issued by a bank. When you buy an ETN, the bank promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN will increase if the gold price goes up.

The beauty of the ETN structure is that it can be linked to anything. There are ETNs that track commodities, and ETNs that track hard-to-reach corners of the equity market. They sometimes combine stock or bond positions with options overlays, or use other sophisticated strategies that would be difficult to package into a traditional ETF. In the commodity space, the ETN also offers significant long-term tax advantages compared with most ETFs.

The downside of an ETN is that if the underlying bank goes bankrupt, you lose essentially all of your money. There were, for instance, a few ETNs backed by Lehman Brothers. While most investors in Lehman's ETNs fled before the firm shut down, anyone who held to the bitter end probably still has a bad taste in their mouth.

The good news is that this credit risk in most situations is very minor. Institutional investors can "redeem" (get their money back) from the underwriter of an ETN on a daily basis. While anything can happen, you can usually see major bank defaults coming more than a day or two ahead of time.

The even-better news is that credit risk is easily monitored. Here at ETF.com, we monitor and report on the credit risk of every ETN on a daily basis. We do that by watching the cost of credit default swaps (CDS) on the underwriting banks each day. CDS are like insurance—investors buy them to protect themselves against a company's default—so they are the best possible view of the likelihood a bank will go down.

How do you check? Just pull up the Efficiency Tab on any ETN (e.g., www.etf.com/AMJ) and check out the ETN Counterparty Risk measure. If it says "Low," you're OK. If it says "High," run for the hills.

Next: ETFs Vs. Mutual Funds: Which Is Right For You?

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