The popularity of ETF investing has given rise to the growth of other exchange-traded products (ETPs). One such vehicle is the ETN, or exchange traded note. The number of ETFs in the marketplace and the value of their underlying assets are still exponentially higher than for ETNs. While there are many similarities between ETFs and ETNs, investors need to understand the differences, too.
While both ETFs and ETNs are ETPs, their structures are a bit different.
An ETF is a fund that is made up of the underlying securities it tracks. If you are buying an ETF that tracks large cap stocks, the ETF will hold shares of those large cap stocks. The net asset value (NAV) of the ETF is the weighted average of those underlying holdings, and the returns will be based on the performance of the underlying holdings and any spread between the NAV and the ETF's market price.
ETNs are unsecured debt instruments issued by a financial institution. They are structured products whose performance is linked to the index or benchmark they are tracking, less the ETN's underlying expenses. Unlike other fixed income vehicles, the ETN trades on the exchange and can have a maturity of anywhere from 10 to 30 years or more. Like bonds, however, the ETN holder can be impacted if the issuer experiences financial difficulties.
Comparing ETFs to ETNs
Here are some attributes to consider when comparing these two ETPs:
Risk. The main risk associated with an ETF is the risk inherent in the underlying securities held within the portfolio. For example, the investment risk for a short-term fixed income ETF would be considerably different than an ETF that invests in emerging market stocks.
ETN investors are exposed not only to the risks associated with the market segment or index being tracked, but also to the same risks that any holder of an individual bond faces, including credit and default risk. While ETNs are generally issued by large, well-capitalized financial institutions, some were issued by banks that were considered too big to fail before the financial crisis of the last decade.
Taxes. ETFs can generate taxable income for investors via either capital gains from the sale of underlying holdings, dividends or interest payment from holdings. ETNs are often put into the fixed income category and historically track a declared benchmark. They don't actually hold any actual securities and consequently don't generate taxable income from internal operations of the fund via capital gains or dividends. That said, however, there are some tax issues with ETNs. Those tracking a commodity benchmark, for example, may incur the same tax issues as commodity futures.
Tracking differences. This term refers to the differences in price behavior or performance of an ETF from the declared benchmark. Because ETNs do not hold actual securities, the tracking error is usually minimal. ETNs can experience tracking differences, however, if the price at which they trade results in a wide bid/ask spread - which can also happen with an ETF.
ETFs can experience tracking errors and differences depending on the internal index process. Potentially short-term differences can also arise from liquidity issues from the underlying holdings of the fund such as with funds that invest in emerging market stocks. These liquidity issues may contribute to potentially higher expense ratios and transaction costs, which may detract from investor returns.
ETNs are similar to ETFs in that they are both exchange traded vehicles, but there are differences that investors need to understand. As with any investment that you may be considering, be sure to look under the hood to see if it meets your financial goals and that you understand both the upside potential and the downside risk factors including any tax-related issues.