Exchange traded funds (ETFs) are the hottest thing since the mutual fund. In fact, the investment product is on track to replace mutual funds with its often-lower fee structure and easier-to-understand stock-like price action.

ETFs have a not-so-well-known cousin. The exchanged traded note (ETN) is something that many retail investors may not know about. It is time to shed some light on the ETN and decide if this product has a place in your portfolio.

How Are They different?

In practice, the two are very similar. Both are designed to track an underlying asset, both often have lower expense ratios than actively managed mutual funds, and both trade on the major exchanges just like stock.

The main difference is under the hood. When you invest in an ETF, you are investing into a fund that holds the asset it tracks. That asset may be stocks, bonds, gold or other commodities, or futures contracts.

An ETN is more like a bond. It's an unsecured debt note issued by an institution. Just like with a bond, an ETN can be held to maturity, bought or sold at will, and if the underwriter (usually a bank) were to go bankrupt, the investor would risk a total default.

For that reason, before investing in an ETN, research into the credit rating of the underwriter is an important metric. If the underwriter were to receive a credit downgrade, shares of the ETN would likely experience a downturn unrelated to the underlying product it's tracking.

Because an ETN doesn't buy and sell assets within the funds like an ETF, taxes are not triggered until the fund is sold - often years later. This will trigger long-term capital gains (which have a lower tax rate) rather than short-term capital gains.

No Tracking Errors

Another advantage to ETN investing is the lack of tracking errors. There are more than 4,300 ETFs currently on the market. They achieve varying levels of success when tracking their respective index. Because of expenses, investors will notice some amount of divergence from the index they track, making the fund underperform the index over time.

This does not happen with ETNs. Because an ETN does not rely on the buying and selling of the underlying asset, expenses are not amassed. An ETN simply pays investors once the fund matures based on the price of the asset or index. There's no tracking error because the fund itself isn't actively tracking. Market forces will cause the fund to track the underlying instrument, but it's not the fund doing the tracking.

Which Is Better?

If you follow the age-old rule that says you should invest only into what you understand, ETFs are a better choice. Part-time investors have an easier time understanding products with stock-like characteristics. Since an ETN has bond-like characteristics, it's more complicated.

The most popular exchange traded products are ETFs. One of most popular ETNs is the JP Morgan Alerian MLP Index ETN (ARCA:AMJ), which has an average volume of a little over 1.8 million shares. The SPDR S&P 500 (ARCA:SPY) ETF, by contrast, has an average daily volume of over 85 million shares. This clearly shows that investor appetite is heavily weighted toward ETFs.

Don't count out ETNs. These funds are more efficient than some ETFs and have, at least for now, favorable tax treatment for longer-term investors.

The Bottom Line

ETFs are exponentially larger in collective volume than ETNs, but much like stocks versus bonds, stocks receive more attention from retail investors because they are easier to understand. Deciding that ETNs are right for your portfolio is appropriate, provided you have done research and gained an appropriate level of understanding with which to make that determination.

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