You have probably heard of exchange traded funds (ETFs), but you may be unfamiliar with exchange traded notes (ETNs). They are similar in that both track some form of asset, trade on the major stock exchanges and have relatively low expense ratios compared to an actively managed fund. The main difference, and most of the differences that follow, relate to the underlying assets.
ETFs actually hold the assets that they attempts to track, whether the assets are stocks, bonds, commodities, precious metals, or other financial entities. Returns are based on the assets that are held by the fund. Assets are managed to stay on track with the index.
In contrast, ETNs are debt notes — unsecured debt issued by a financial institution (typically a bank). Their returns are based on a market index, but there are no holdings in the indexed assets. ETNs act like bonds in several ways. They can be held to maturity and redeemed for the cash amount based on the index on that day, and may be bought and sold at any point in the life of the note.
Whether an ETF or an ETN is right for you primarily depends on their differences in three important aspects.
- Risk – Risk for an ETF is based on the assets that are held and the ability of the fund to properly track that asset. An ETN has a second layer of risk since the underlying debt is unsecured. Should the credit rating of the debt issuer drop, the ETN value will drop independently of the index, and in case of bankruptcy, the investor could face a default situation. In essence, ETNs have two potential mechanisms for a decrease in value.
Even so, there may be tracking error involved in an ETF, since the ability to track the index properly is dependent upon the fund’s management. Thus, one could argue there are also two levels of error with an ETF: the value of the underlying stocks and the failure to track the index properly.
- Taxes – Tax treatments of ETFs are complicated, and taxation rules of ETNs are still relatively murky, so verify the latest tax status with the IRS or a trained tax professional before investing. However, we can make a few important generalizations.
Currently, ETNs are taxed when the ETNs are sold or redeemed for profit and are subject to capital gains taxes. Short-term income from ETNs is taxed at the rate of ordinary income; beyond one year of holding, ETNs are taxed at the lower long-term capital gains rate upon sale.
Taxation of ETFs is not straightforward since their value depends on the underlying assets. As a general rule, ETFs are taxed along with the tax rules of the sector in which the ETF is invested. Your ETF may or may not have the same type of tax advantage as an ETN.
- Diversification – ETFs are diversified because they are invested in multiple assets, which can range across asset classes. ETNs are simply ownership of debt from the issuer and offer no diversification of holdings.
ETFs are simpler for the novice investor to understand, but ETNs can offer advantages if you can handle the risks, and the tax advantages provide an improvement for the same relative amount of return. To determine which type of investment is best for you, select some promising options from a screening list of ETFs and ETNs and check the prospectus to see if the details fit your needs. Do not hesitate to seek the advice of a qualified tax professional if you need help.