ETF vs. ETN: An Overview
Exchange-traded funds (ETFs) have grown in popularity since their introduction in the 1990s. They generally have lower fees than mutual funds and are easier to understand since most mirror stock indexes or other benchmarks. Best of all, they can be bought and sold on exchanges, like stocks.
But ETFs have a lesser-known cousin, the exchange-traded note (ETN). It has some of the characteristics of bonds but, like most ETFs, the underlying investments are chosen to mirror an index or other benchmark.
Key Takeaways
- Both ETFs and ETNs are designed to mirror the investments tracked by an index or other benchmark.
- When you invest in an ETF, you are investing in a fund that buys and holds shares of the assets in the benchmark it tracks.
- An ETN is more like a bond. It's an unsecured debt note issued by an institution.
Exchange-Traded Funds (ETFs)
ETFs and ETNs have similar characteristics. Both mirror the assets contained in an index or other benchmark. Both have lower expense ratios than actively managed mutual funds. And both trade on major exchanges like stocks.
When you invest in an ETF, you are investing in a fund that buys and holds the assets it tracks. If it's an S&P 500 Index, it invests its clients' money in all 500 of those stocks, in the same proportion in which they're represented in the index. It will gain (or lose) money from hour to hour in the market, just like the S&P. (There can be minor differences in the results. This is referred to as "tracking error.")
There's a huge variety of ETFs to choose from, including not just stock funds but funds that invest in bonds, gold or other commodities, futures, or a mix of assets. Many focus on a single industry or sector. In January 2024, the first bitcoin futures ETFs were added to the mix.
Exchange-Traded Notes (ETNs)
An ETN also tracks an index, and the returns it pays out are based on the performance of that index. Like an ETF, an ETN can be bought or sold on an exchange.
However, the ETN does not own the underlying assets. An ETN is an investment in debt, similar to a bond. It's an unsecured debt note issued by a bank.
Just like a bond, an ETN can be held to maturity or bought and sold at will. If the underwriter (usually a bank) were to go bankrupt, the investor risks losing the entire investment.
For that reason, anyone considering investing in an ETN needs to check the credit rating of the underwriter. If the underwriter were to receive a credit downgrade, shares of the ETN would probably experience a downturn that is unrelated to the underlying index it's tracking.
Unlike many ETFs, an ETN does not pay dividends or interest on the earnings of the underlying index to its investors. It doesn't own those assets and therefore doesn't receive any dividends or interest.
Investors in ETNs get their profits when they sell the ETN or when it matures.
They also owe taxes on the long-term gains they receive. Profits and losses on ETNs are reported on IRS Schedule K-1, used to report income on pass-through entities (rather than on IRS Form 1099, which is used for capital gains taxes on stocks and ETFs.)
Warning: Rules change, and new rules are imposed. It's always best to talk to a tax expert before filing.
Don't count out ETNs. These funds are more efficient than some ETFs and have favorable tax treatment.
Key Differences
ETNs tend to have lower tracking errors than some ETFs.
These errors are caused by factors like illiquid components. Prices can simply move too fast to achieve a precise match.
Tracking error is virtually eliminated with ETNs. The issuer has agreed to pay the full value of the index (less the expense ratio) at maturity.
An ETN pays investors once the fund matures based on the price of the asset or index. There's no tracking error because the fund itself isn't actively tracking. Market forces will cause the fund to track the underlying instrument, but it's not the fund doing the tracking.
Tax Advantage of ETNs
ETNs have a tax advantage over many other investments, including ETFs, because they do not pay taxable dividends and interest. This is a trade-off. Some investors are better off only owing the taxes due when the ETN is sold or reaches its maturity.
That said, ETNs are a relatively new investment vehicle and there isn't a long history of IRS treatment of special cases to rely upon. Investors in ETNs would be wise to consult a tax professional about any specific exceptions to the rules or changes in their interpretation that may affect their holdings.
Niche Access
One of the guiding principles behind ETNs is to give investors a shot at niche investing areas such as commodities, currencies, and emerging markets.
There are plenty of niche products available as ETFs as well. But the overwhelming favorite among ETF investors remains the old reliable S&P 500 Index tracking ETF.
Which Is Better?
If you follow the age-old rule that says you should invest only in what you understand, ETFs are a better choice. The ETN is a relative newcomer to the investing world, and it's complicated.
The most popular exchange-traded products are ETFs, especially those that are tied to the S&P 500 Index. They offer investors a stake in a broad range of the largest and most successful American companies.
One of the most popular ETNs is the JP Morgan Alerian MLP Index ETN (AMJ), which has an average daily volume of over 400,000 shares. The SPDRS&P 500 (SPY) ETF, by contrast, has an average daily volume of over 110 million shares.
This clearly shows that investor appetite is heavily weighted toward ETFs.
Are ETNs a Risky Investment?
ETNs have the same risks as bonds. There is the risk of default by the issuer. In that respect, an ETN is like an unsecured bond. If the institution goes down in flames, so does your investment.
The performance of an ETN is tied to a specific index. The ETN's value fluctuates with that index. In this respect, an ETN is like an ETF.
Nevertheless, the ETN's performance can be affected from two distinct directions: the market direction of the underlying index and the fortunes of the institution that issues the ETN.
Are ETNs Riskier Than ETFs?
Generally, ETNs are considered riskier than ETFs because they combine default risk and market risk.
An ETF can decline sharply if the market tanks, but it would take a genuine catastrophe to render it worthless. If an ETN's issuer defaults, the ETN is worthless.
Does an ETN Own the Assets in the Index?
An ETN owns nothing but an IOU. It is a promise to repay a loan after a set time period, typically 20 or 30 years. If an investor sells the IOU earlier than the maturity date, the seller receives an amount that is based on the index that the ETN tracks.
The Bottom Line
ETFs reward their investors when the underlying index or benchmark rises in value. The same goes for ETNs. An investor in either can watch their assets fluctuate in value from day to day, and can pull the trigger to sell at will.
There are differences, however. ETNs do not own the underlying assets that they track. They are bond-like investments and their risks are tied to the health of the institution that issues them.
