Exchange-traded notes (ETN), are close cousins to exchange-traded funds (ETFs), but there are some key structural differences.
For investors interested in exploring this kind of investment, it's important to know how they work when it comes to index investing and compared to ETFs.
Key Takeaways
- Exchange-traded notes (ETNs) are unsecured debt securities that track an underlying index of securities.
- ETNs are different from exchange-traded funds, which also track an underlying index of securities, but trade like a stock.
- ETNs bring some credit risk that ETFs don't have, while ETFs bring tracking risk. They are also taxed differently.
- Because ETNs don't hold portfolio securities, there are no dividend or interest rate payments paid to investors while they own the ETN.Only when the investor sells the ETN are they subject to a long-term capital gains tax.
- This contrasts with conventional ETFs, in which a long-term holder would be subject to capital gains tax each year.
ETN vs. ETF
ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. ETNs are more like bonds in that they are unsecured. ETFs provide investments into a fund that holds the assets it tracks, like stocks, bonds, or gold.
Barclays Bank PLC, a 300-year-old financial institution with hundreds of millions in assets and a good credit rating from Standard & Poor's, provides its ETNs with a fairly dependable backing. But even with this kind of credibility, the investments are not free of credit risk. Despite its reputation, Barclays will never be as safe as a central bank, as we witnessed with the downfall of major banks, such as Lehman Brothers and Bear Stearns, during the 207-2009 financial crisis. Even more stringent regulations requiring more safety capital don’t make banks completely immune from collapse.
Distinctions in Tax Treatment
ETNs track their underlying indexes minus an annual expense per year. Unlike ETFs, there are no tracking errors with ETNs.
Investors should treat ETNs as prepaid contracts. This means that any difference between the sale and purchase will be classified as capital gains. In comparison, the return from commodity-basedETFswill come from the interest on Treasury bills, short-term capital gains realized on the rolling of futurescontracts, and long-term capital gains.
Since long-term capital gains are treated more favorably than short-term capital gains and interest, the tax treatment of ETNs should be more favorable than that of ETFs.
However, the owner of an ETN will owe income taxes on interest or coupon payments made by the ETN. For international investors, the differences are compounded as a treatment for these capital gains and will be treated differently in their home countries.
Exchange-traded notes (ETNs) are similar to bonds, while exchange-traded funds (ETFs) are similar to stocks.
Different Risks
Outside of the tax treatment, the difference between ETNs and ETFs comes down to credit risk versus tracking risk.
ETNs possess credit risk, so if Barclays would go bankrupt, investors may have to get in line behind bigger creditors, and not receive the return they were promised. An ETF, on the other hand, has virtually no credit risk. But there is tracking risk involved with holding an ETF. In other words, there is a possibility that the ETF's returns will differ from its underlying index.
Which Is Better?
Now that you have a better understanding of the differences between ETNs and ETFs, which one should you choose? To some degree that will be determined by your tax bracket and your investment time horizon.
While the biggest benefit of an ETN is that the entire gain is treated as a capital gain, this gain is also deferred until the security is either sold or matures. That is something that should not be taken lightly by tax-conscious, long-term investors. With an ETF, capital gains and losses are realized as each futures contract is rolled into another one.
The Bottom Line
The big difference between ETNs and ETFs is between credit risk and tax treatment.
While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1980s. Financial engineering has made our markets more liquid and more efficient. The creation of the ETN is a development all investors should learn about and consider adding to their portfolios.
FAQs
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.
What is the difference between an ETF and an exchange traded note? ›
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.
Are exchange-traded funds known as ETFs? ›
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
What is an alternative ETF? ›
Alternative ETFs aim to deliver returns that are not closely correlated with traditional market indexes, providing investors with diversification benefits and potential for enhanced risk-adjusted returns.
Is an exchange fund the same as an ETF? ›
Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains. Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.
What is the advantage to an exchange-traded note? ›
Benefits of ETNs
Instead, any gain (or loss) is deferred until the ETN is sold or matures. It is treated as a long-term capital gain, which receives a more favorable treatment (lower tax rate of 20%) than short-term capital gains.
Are exchange-traded notes risky? ›
Exchange-traded notes (ETNs) have risks such as liquidity risk, credit risk, closure risk, volatility risk, and price deviation risk.
What are the three types of ETFs? ›
Common types of ETFs available today
- Equity ETFs. Equity ETFs track an index of equities. ...
- Bond/Fixed Income ETFs. It's important to diversify your portfolio2. ...
- Commodity ETFs3 ...
- Currency ETFs. ...
- Specialty ETFs. ...
- Factor ETFs. ...
- Sustainable ETFs.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
What are the advantages of investing in exchange-traded funds? ›
ETFs typically track a specific market index, sector, commodity, or other asset class, exposing investors to a range of securities in a single investment. Their benefits include liquidity, lower expenses than mutual funds, diversification, and tax advantages.
While ETFs provide liquidity, lower expense ratios, and tax efficiency, mutual funds offer active management and broader diversification. Understanding the differences between ETFs vs mutual funds is crucial for investors to align their investment strategies with their financial goals and risk tolerance levels.
Can you live off ETF? ›
While it is possible to live off ETF dividends, you'll need to do some careful planning to make it happen. You'll need to balance how much income your investments bring in and how much you spend.
What is the opposite of an ETF? ›
Key Takeaways. An inverse ETF is a fund constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Inverse ETFs allow investors to make money when the market or the underlying index declines, but without having to sell anything short.
What is the difference between an ETF and an exchange-traded fund? ›
Then there are exchange-traded funds that are similar to MFs in that both of these are investment options where money pooled in from investors is put into a basket of securities. An ETF basically copies an index, which means that it usually consists of stocks of different companies as present in the particular index.
What is the 7 year rule for exchange funds? ›
While exchange funds provide diversification, they will not protect against broad market declines. Investors must remain in a fund for at least seven years before redeeming shares, and those who leave prematurely may face penalties and only receive their original shares back.
What are the pros and cons of exchange funds? ›
Are Exchange Funds a good idea? Yes, exchange funds is a good option for investors with concentrated stock holdings looking to diversify their portfolios while deferring taxes. They come with some disadvantages, such as deferred tax liability, fees, complexity, limited availability, and less control over investments.
What is the difference between ETF and ETC? ›
The main differences between an ETF and an ETC are: Underlying Assets: ETFs can hold a variety of assets such as stocks, bonds, or a combination of different asset classes. ETCs specifically track the performance of commodities such as precious metals (gold, silver), energy resources, or agricultural products.
What is the difference between an ETF and an ETP? ›
Exchange-traded products (ETPs) are accessible investments offering diversification and liquidity. Exchange-traded funds (ETFs) are a specific type of ETP that tracks an underlying index and can be bought and sold on an exchange throughout the trading day.
