What’s the difference between ETFs and ETNs?

[Walter Peters]

[Sheila Olson]

It’s easy for investors to mix up ETFs and ETNs, since they are both exchange traded products. However, the two are quite different structurally, and have quite different risks and advantages. Exchange traded notes, or ETNs, are unsecured debt notes issued by a bank or financial institution. They function more like bonds, in that they promise to pay a specific return over a certain period of time. ETNs, like bonds, can be held until they mature, or they can be traded at will. ETFs actually hold the assets in the index they track; an ETF tracking the S&P 500 will have a basket of approximately 500 different securities. ETNs, on the other hand, do not hold any assets. They are backed by the credit of the issuing financial institution; in effect, you are making an unsecured loan to the bank. If the issuing bank fails, as Lehman Bros did in 2008, with over $13 million in outstanding ETNs, investors have few options to recover their money. That said, however, ETNs generally present a very low credit risk, and because they can be redeemed on a daily basis, it’s easy to get out if a financial institution shows signs of default. ETNs backed by institutions such as Barclays, which has a very high credit rating, present a very low risk of default. Although ETNs can be linked to almost anything, there are four main types available to retail investors:

• Currency ETNs can track a single currency, such as the British pound, or a basket of foreign currencies.
• Commodities ETNs use derivatives to track the price movements of a single commodity, such as gold, or a commodities index, such as the CMCI Food Index.
• Emerging markets ETNs offer exposure to indices tracking an emerging market, such as the MSCI India Index.
• Strategy ETNs are structured around different investing strategies, such as smoothing out volatility in a stock index with a volatility ETN.

  The beauty of ETNs is that they can offer more sophisticated strategies than a traditional ETF, such as combining stock positions with options overlays to maximize returns while still managing risk. There are other structural differences between ETNs and ETFs that may be advantageous, depending on investment goals and overall portfolio composition. For example, tracking error inherent in ETFs is not an issue with ETNs because there is no buying or selling of underlying assets within the fund. On maturity, the note simply pays out investors based on the price of the index (or whatever underlying asset it’s tracking). Tax distinctions also play into the decision to buy ETNs over ETFs. ETNs are only taxed when they are redeemed, and the tax rate is based on the length of time they were held. If ETNs are held more than 12 months, long-term capital gains rates apply, which are typically much lower than short-term rates. In addition, there are no issues with dividend or interest income, as there may be with ETFs. One caveat, however: Currency ETNs are treated differently in that they are treated like normal debt for tax purposes. Interest income is taxed, even though it isn’t paid out until the note is redeemed. Gains and losses on currency ETNs are also treated as ordinary income for tax purposes, and investors cannot elect to treat them as capital gains. Finally, ETNs are significantly more expensive than ETFs, with an expense ratio of 0.75% across the board. This is orders of magnitude higher than rates for the most popular ETFs, which charge rates of 0.05% or lower. Liquidity is one last thing investors should keep in mind before buying ETNs. There are far fewer ETNs on the market than ETFs, and their trading volume is quite low compared to ETFs. For example, the iShares Dow Jones-UBS Commodity ETN (DJP), one of the more popular ETNs on the market, has roughly $800 million in assets under management and an average daily trading volume of around 375,000 shares. On the other hand, the SPDR S&P 500 ETF, the largest and most popular ETF by far, has over $300 billion in assets under management and a daily trading volume averaging around 120,000,000 shares.