If you are someone that believes that the stock market always wins in the long-term, you may be interested in trying some inversions. However, the volatility is very high; and by investing in a single stock, even if it is one of the so-called blue chips, we need to assume a high risk.
In that framework, we think investing on indexes make sense. An index usually includes the strongest stocks in a country. As a result, it is usually well diversified among different economic sectors in that country. Furthermore, indexes renew its members regularly. This means that when a stock behaves badly, it is removed and substituted by a new stock. Therefore, indexes have a good survival bias and are safer than most of the stocks in the market. One way to invest on indexes is doing it through ETFs and ETNs, but what is the difference?
ETFs Vs. ETNs
On one hand, an ETF is an Exchange Trading Fund. It represents real positions on the assets. For example, an S&P 500 ETF is a fund that distributes its money among all the S&P 500 stocks. It tries to invest in each stock of the index an amount that equals the share that the stock represents in the index. In other words, if Apple is about 5 percent of the S&P 500, then 5 percent of the money in the fund will be invested in Apple.
This way, the ETF tries to represent the index as good as possible.
On the other hand, an ETN represents senior debt. Senior debt means that there is a financial institution that commits to pay the ETN value if that financial institution decides to close the ETN or goes out of the market. In other words, when you invest in an ETN, you are a creditor of a single financial institution. The value of the ETN is linked to the value of the index to which it is referred.
ETFs and ETNs may have different tax treatments, but we want to focus on their risk difference.
In both of them, you assume the risk that the underlying asset price goes in the opposite direction than your position and you may lose money. That is no different from any other investment.
In addition to that, an ETF may not track the index perfectly. It needs to adjust all the time to the market variations, and this involves some small differences with the original index. These small differences in the long-term can be significant.
When it comes to the ETN, the tracking is perfect, but there is an additional risk related to the bankruptcy of the ETN provider. No matter how good your investment is, if the institution that created the ETN does not have money anymore, you will not be able to cash in the investment. With the ETFs you do not have this problem because, if needed, you will be able to go to the market to sell the stocks.
These are just two additional investment options you have in the market these days. If you are interested, we recommend that you ask your financial advisor to get more in depth information.