The Difference Between ETFs vs. ETNs

In the past, we’ve discussed the importance of knowing the structure of any given financial instruments you trade or invest in order to avoid unpleasant surprises.

Today, let’s take a look at the differences between Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs).

People often use the terms interchangeably, and indeed, they have many similarities, or they simply assume most of these investment vehicles are structured as ETFs, which kind of makes sense given there are over 3,000 ETFS compared to just over 100 ETNs.

ETFs and ETNs are both exchange-traded products, which means they trade like stocks on a stock exchange. Unlike mutual funds, which can only be purchased or redeemed based on closing prices, ETFS and ETNs can be bought and sold throughout the day.

The main feature differentiating ETFs from ETNs is that ETFs hold a portfolio of securities, such as stocks, bonds, or commodities, and are designed to track the performance of an underlying index.

ETNs, on the other hand, are debt instruments issued by financial institutions, such as banks, that are backed by the creditworthiness of the issuer and designed to track the performance of a specific index or benchmark but they are not backed by any assets. The issuer is promising to pay exactly the return on an index (minus its own expenses, of course), there’s little risk of tracking error.

That is, the ETN should be expected to very closely match the performance of the index. Of course, well-managed ETFs can do the same thing, but an ETN comes with an explicit promise.

Because ETNs do not own any securities, when ETNs are created or redeemed, the ETN issuer determines the value of the note via a preset (and published) formula called the “indicative value.”

By contrast, given ETFs hold underlying securities, the holders of ETF shares essentially own a piece of those securities—stocks, bonds, or commodities, for example. When an ETF is created or redeemed, the value of the underlying holdings determines the fund’s net asset value (NAV).

Each day, ETF issuers disclose the NAV. The fund can sometimes trade at a discount or premium to the NAV which may help you determine if it is an attractive buy or sale.

It’s also important to be aware ETNs carry counterparty risk, which means that the investor is exposed to the creditworthiness of the issuer. If the issuer defaults, the investor may lose their entire investment. ETFs, on the other hand, are structured as investment funds and do not have this counterparty risk.

For this reason ETNs are generally considered riskier than ETFs because they combine default risk and market risk.

An ETF can decline sharply if the market tanks, but it would take a real catastrophe to render an ETF worthless. If an ETN’s issuer defaults, the ETN may be worthless. We saw this occur in 2018 when two popular ETNs based on the CBOE S&P 500 Volatility Index (VIX) imploded, went down over 99% in a day and closed down shortly thereafter.

Lastly, there are tax considerations. ETFs are generally more tax-efficient than ETNs because they are structured as investment funds and are subject to different tax rules. ETFs typically distribute capital gains annually, whereas ETNs may be subject to ordinary income tax rates when sold. As always, consult a qualified accountant or specialist before making any decisions that have tax implications.

Many of the most popular funds, such the SPDR S&P 500 (SPY) are structured as ETFs. Whereas a number of niche or specialized strategies, such as commodity based, or leverage or inverse funds such as the Nasdaq 3x Leverage (TQQQ), are structured as ETNs.

Basically, financial institutions create ETNs based on a particular strategy or index. ETN issuers can create unique products that offer investors exposure to parts of the market that would be difficult to package with an ETF.

Again, it’s crucial to understand the structure and features and their potential impact on every fund you consider before adding it to your portfolio.

To learn more about ETFs and ETNs and how similar products compare go to Magnifi.com and take your new investing mentor for a spin.