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ETFs and ETNs: With similar abbreviations, it may be easy to get confused about how these types of investments work. With exchange-traded funds (ETFs) and exchange-traded notes (ETNs), they might have some of the same letters, but they’re quite different from each other.
Here are what ETFs and ETNs are and some of the key differences between them.
What is an exchange-traded fund (ETF)?
An ETF is a type of fund that pools securities together into one fund and is traded on a stock exchange. Generally, ETFs track a specific index of assets, making them passive investments. Many types of ETFs exist, and ETFs are based on different indexes of stocks and bonds. The most popular ETFs are based on the S&P 500 Index, a collection of America’s top companies.
ETFs are bought and sold like stock. They have ticker symbols, pricing data, and are traded throughout the day while the markets are open.
ETFs are best for long-term investors looking to get into the market without putting all their money into a handful of individual stocks and securities. Rather than having to buy all the individual stocks, investors can buy the ETF and own a (small) slice of all the investments. So, investors can easily add them to a portfolio for instant diversification.
ETFs are similar to mutual funds since they’re both made up of a collection of assets, but they aren’t the same. Mutual funds have higher minimum investments and they trade only at the end of the day. Mutual fund prices are the same no matter the time of day you trade them, while ETF prices change throughout the day like stocks.
What is an exchange-traded note (ETN)?
ETNs also track a benchmark index and are traded on a stock exchange like an ETF. However, ETNs are senior unsecured debt notes issued by a bank. They can be bought and sold at will, just like a bond, and at maturity, the issuer will pay out the performance of the index minus any management fee on the ETN. So the ETN is really a bet on the direction of the underlying index.
Your risk? You’re betting on the direction of the underlying index, so you could lose money if it moves in the wrong direction. But ETNs have an additional risk not present in ETFs. If the issuer goes bankrupt or defaults on the note, you might not get your money back from the ETN.
Unlike ETFs, which actually own securities, ETNs don’t own anything but a promise from the issuing bank to repay the note. That means ETNs do not pay dividends or interest, reducing short-term tax liabilities, compared to ETFs. When you sell the ETN, you’re on the hook for capital gains tax, at either long-term rates or short-term rates, depending on your holding period.
Differences between ETFs and ETNs
Aside from most of the same letters, ETFs and ETNs aren’t all that similar. Here are some major differences.
|Act and trade like:
|Whatever they own
|Whatever they track
|Can pay out dividends?
|Market risk and credit risk of the issuer
|Form 1099, short-term and long-term capital gains
|Schedule K-1, short-term and long-term capital gains
Are ETFs better than ETNs?
ETFs may be better than ETNs in many circumstances. It comes down to risk and the type of investor you are. ETFs might be better if:
- You’re familiar with them. ETFs are a popular type of security not only for seasoned investors, but also for newbies. Chances are you’ve heard more about ETFs than the unknown of ETNs, which were developed only in 2006.
- You like the range of choice. You can buy ETFs from nearly every online broker, and there are a lot more ETFs than ETNs, giving you plenty of choices.
- You don’t mind the taxes. Some ETFs offer dividends, which is a regular payout to you as an investor. But those dividends are subject to tax.
ETNs might be better if:
- You need exposure to a niche area. ETNs can be valuable if you’re looking for a niche area of the market that’s not covered by ETFs.
- You want to defer taxes. ETNs don’t get taxed until the security matures or you sell it. You can defer taxes by holding an ETN, and if you hold for more than a year, you’ll enjoy long-term capital gains.
- You don’t mind hunting for them. There are thousands of ETFs but only a little more than 100 ETNs are currently being traded right now.
- You’re OK with the extra risk. ETNs are subjected to market risk but also the credit risk of the issuer, so you could lose your investment if the bank defaults. You can evaluate a bank’s credit rating before buying, but investing in ETNs has this added risk.
ETFs are a good solution for investors, offering exposure to a basket of assets usually at a low cost. ETFs are lower risk than ETNs, which present investors with market and credit risk, meaning you could lose your investment if the bank defaults. But ETNs may offer investors exposure to arcane areas of the market that are not easily accessible with ETFs.