ETF’s and ETN’s; What are They and How do They Work?

ETF’s and ETN’s; What are They and How do They Work?

ETF – Exchange-Traded Fund – Represents a stake in the underlying commodity, holds the assets it tracks.
ETN – Exchange-Traded Note – Structured product that is issued as senior-debt notes (debt that possesses the highest priority if the company goes bankrupt).

Inverse ETF/ETN – Designed to return the exact opposite performance of the underlying index/benchmark (in percentage gains/losses).
Leveraged ETF/ETN – Designed to use financial derivatives and/or debt to amplify returns of the underlying index/benchmark (in percentage gains/losses). Usually provides a ratio of leverage against the underlying (1.5x, 2x, 3x, etc.). This can be thought of as an amplification of beta against the respective index being tracked.

It is important to understand the concept of compounding and when it is being applied to the pricing of the fund (usually daily). Compounding is also known as decay when it is applied to the decrease in the overall price of the fund. Here is a simple example of how this works:
One major factor seen in leveraged ETFs is decay. This decay is a function of the math behind having a multiplier. Let’s use the example of two ETFs. The first, ABC, is an ETF that tracks the Big Index. The second, XYZ, is a leveraged ETF that returns 2x the Big Index. Both the ABC and XYZ ETFs start off trading at $10 per share. Day 1, the Big Index is up 25%. The next day, the Big Index drops 20%.

After the first day, ABC rallies from $10 to $12.50, up 25% and in step with the Big Index, while XYZ goes from $10 to $15. The second day, ABC shares give back 20% or $2.50, to close back at $10. XYZ, on the other hand, gives up twice the 20% of the Big Index, 40% or $6, to close the day at $9. Even though the Big Index and the ABC ETF are both breakeven from where they started, the leveraged ETF, XYZ, is down $1, trading below where it started the previous day. In terms of leveraged ETFs, decay is the loss of performance attributed to the multiplying effect on returns of the underlying index of leveraged ETFs. In this example, the decay took $1 or 10% off the performance of the leveraged ETF.

Leveraged funds will often perform reverse stock splits once the price reaches less desirable levels.

Another concept to understand is contango/backwardation. This applies to ETFs with exposure to their underlying market index via futures (most commodity ETFs). Essentially, due to the fact that futures contracts are expiring assets, the fund managers are required to ‘roll’ expiring contracts into the next time frame (monthly) contracts to provide exposure to the underlying. If the next month’s contracts are priced higher than the preceding month’s, the commodity is said to be in contango and the fund will see its value decrease due to the fact that it cannot purchase the same ‘amount’ of commodity futures contracts with the sale of the preceding month’s contracts and therefore must fund the remaining purchase. Similarly, If the next month’s contracts are priced lower than the preceding month’s, the commodity is said to be in backwardation and the fund will see its value increase due to the fact that it can purchase the same ‘amount’ of commodity futures contracts for less.

Commodities Examples

Natural Gas:

UGAZ – VelocityShares 3X Long Natural Gas ETN
DGAZ – VelocityShares 3X Inverse Natural Gas ETN
NG – Henry Hub Natural Gas Futures
SPGSNG – S&P GSCI Natural Gas Index

Crude Oil:

UWT – VelocityShares 3x Long Crude Oil ETN
DWT – VelocityShares 3x Inverse Crude Oil ETN
CL – NYMEX WTI Light Sweet Crude Oil Futures
SPGSCL – S&P GSCI Crude Oil Index

Gold:

UGLD – VelocityShares 3X Long Gold ETN
DGLD – VelocityShares 3X Inverse Gold ETN
GC – COMEX Gold Futures
SPGSGC – S&P GSCI Gold Index

Silver:

USLV – VelocityShares 3X Long Silver ETN
DSLV – VelocityShares 3X Inverse Silver ETN
SI – NYMEX Silver Futures
SPGSSI – S&P GSCI Silver Index

Volatility Examples (Work In Progress):

TVIX – VelocityShares Daily 2X VIX Short-Term ETN – Reflects twice the return of the S&P VIX Short-Term Futures.>
VIX – CBOE Volatility Index – A measure of the market’s expectation of volatility from S&P 500 index options; quotes the expected annualized change in the S&P 500 index over the following 30 days.

Market Index Examples:

SSO – ProShares Ultra S&P 500 ETF (2x)
UPRO – ProShares UltraPro S&P 500 ETF (3x)
SDS – ProShares UltraShort S&P 500 (-2x)
SPXU – ProShares UltraPro Short S&P 500 (-3x)
TQQQ – ProShares UltraPro QQQ (3x)
SQQQ – ProShares UltraPro Short QQQ (-3x)

Article written by BBT member Jarad Champagne.