Exchange-traded funds (ETFs) are an easy and popular way to add broad exposure to a portfolio with a single trade. While the vast array of ETFs ensures that an investor can find a product to fit any investment goal, there are unique spin-offs of ETFs known as "exchange-traded notes" (ETNs).
Like ETFs, ETNs can also track the performance of an index, sector, or region. However, there are many important differences between the two products. If you are interested in ETFs, then you should know about ETNs as well.
- Exchange-traded funds (ETFs) are shares in bundles of assets pooled together with a specified goal, such as to mirror the performance of an underlying index.
- Exchange-traded notes (ETNs) are shares of corporate debt, similar to bonds, with contracted rates of return based on the market performance of an index or other benchmark.
- ETNs may have advantages over ETFs in taxation and in avoiding tracking errors.
- ETNs may have disadvantages when compared to ETFs in terms of credit risk and liquidity.
ETF vs. ETN
While they trade similarly, ETFs and ETNs are very different investment products. An ETF represents a share in a bundle of assets. Depending on the goals of a particular ETF, those assets may be stocks, bonds, or derivatives like futures and options. Investors who buy the ETF are pooling their money together to buy shares with a specific goal, such as emulating the performance of the S&P 500. An ETN, on the other hand, is essentially unsecured corporate debt, and the investor isn't buying into a bundle of assets.
In other words, an ETF is similar to a mutual fund, while an ETN is similar to a corporate bond. However, unlike the stated rates of interest that come with corporate bonds, ETN returns depend on the market performance of the tracked index or benchmark.
How Taxes Differ
ETNs have some tax advantages, even over ETFs. For example, ETFs usually distribute taxable dividends, whereas ETNs do not. Any profits on the purchase or sale of an ETN are not realized until the actual closing transaction, which is when capital gains taxes are incurred. Some ETNs, such as currency ETNs, are treated differently. It's best to consult a tax expert about any ETNs you're considering.
Avoid Tracking Errors With ETNs
ETNs are treated as prepaid contracts, which eliminates any tracking errors. An investor who owns a note is promised a contracted rate of return by the issuer.
With an ETF, on the other hand, the funds are designed to emulate an index (without trying to outperform it). However, it does not always go according to plan. The difference in performance between an ETF and the index it tracks is known as a "tracking error."
Unique Risks With ETNs
ETNs and ETFs both have certain risks, which differ. The biggest risk with an ETN is credit risk. While an issuing bank like Barclays has a high credit rating from Standard and Poor’s, that does not mean it is infallible. Big banks have tumbled before. If something happens to the issuing bank while you're holding an ETN, it can default, and you can lose your investment.
The other potential risk is associated with liquidity. There are a lot more ETFs in the investing world than ETNs, as of 2021. That reflects the relatively higher demand for ETFs, which means that trading ETN positions might not be as easy as trading ETFs.
If you need to close or open an ETN, you may encounter difficulty due to a lack of trading volume.
While the two risks mentioned above are specific to ETNs, ETFs and ETNs both share the risk of market performance. For example, if an ETN is aiming to replicate the performance of the S&P 500, and the S&P 500 suffers steep losses, then your ETN returns would reflect those losses. As with some ETFs, some ETNs are leveraged or inverse ETNs, and those investments come with extra risks.
ETNs to Watch
Before you make any investment, conduct your due diligence and thoroughly analyze research on the investment. One way to start is by watching how ETNs perform. Here are some ETNs you can keep an eye on.
- DJP: iPath Bloomberg Commodity Index Total Return ETN
- EROTF: iPath EUR/USD Exchange Rate ETN
- EMLBF: iPath Long Enhanced MSCI Emerging Markets Index ETN
Make sure you research each note thoroughly before making any trades. Watch how they react to different market conditions. Understand what is in each note, as well as what is in the underlying index or benchmark. That is especially important to understand when trading leveraged and inverse ETNs, which typically involve derivatives. If you have any questions or concerns about an ETN, be sure to consult a financial professional, such as a broker, financial advisor, or financial planner.