Key differences between exchange traded funds (ETFs) and exchange traded notes (ETNs) can significantly impact overall returns, meaning one could be a better choice than the other for certain investments.

When discussing the universe of exchange traded products now available, many investors group a number of securities under the ETF umbrella, including exchange traded notes (ETNs), grantor trusts, holding company depository receipts, and others.

While these securities are similar in many ways, there are some structural complexities that can potentially impact returns and shouldn’t be overlooked.

Perhaps the most important distinction to make is between exchange traded funds (ETFs) and exchange traded notes. Although these securities are often lumped together as ETFs, they offer exposure to the related asset class in very different ways.

ETFs maintain a portfolio that corresponds to an underlying benchmark. For example, the Russell 1000 Index Fund (IWB) holds equity securities that correspond to the Russell 1000 index. ETNs, on the other hand, are debt securities issued by a financial institution that pay a return linked to the performance of an underlying index.

In other words, ETNs don’t actually hold the assets that comprise the underlying index, and are instead promissory notes that pay returns based on the change in a reference benchmark.

ETNs offer investors both advantages and disadvantages. On the positive side, these securities eliminate tracking error that can plague ETFs. Because ETNs are debt instruments linked to an index, there isn’t actually an underlying basket of securities that can deviate from the benchmark. Moreover, achieving commodity exposure through ETNs may offer enhanced tax efficiency relative to otherwise similar exposure achieved through funds that invest in futures contracts.

The drawbacks of ETNs are primarily related to the credit risk to which investors are exposed. Because these products are debt securities, there exists the potential for investors to be left holding the bag if the financial institution behind the ETN goes under.

While some investors write off the possibility that firms like Barclays or UBS, two banks that have issued billions of dollars worth of exchange traded notes, will go bankrupt, it’s important to be aware of this risk.

Lehman Bros. serves as a cautionary tale; the bank was an issuer of ETNs at the time of its collapse. In some cases, ETNs can be less efficient from a tax perspective since distributions are taxed as interest income.

Holding company depository receipts, or HOLDRS, are also often grouped in with ETFs. But these products, offered by Merrill Lynch, are unique in more ways than one. HOLDRS have a unique structure when it comes to voting rights, and there can be unwanted tax ramifications when component companies are acquired.

Moreover, HOLDRS are subject to significant concentration of assets among just a few stocks, which can make them vulnerable to company-specific developments.

NEXT: Structure Matters

Structure Matters

Even among ETFs, there are some subtle structural differences that can impact the returns delivered by various products. For example, Rydex, WisdomTree, and iPath all offer exchange traded products designed to reflect movements in the value of the euro relative to the US dollar.

The three products aren’t identical, however. The iPath EURO/USD Exchange Rate ETN (ERO) is structured as an exchange traded note, the Currency Shares Euro Trust (FXE) is a grantor trust, and the WisdomTree Dreyfus Euro Fund (EU) is an actively managed ETF.

Those distinctions may not mean much to most investors, but the different structures can lead to unique tax treatments, dispersion of counterparty risk, and ultimately, bottom-line returns.

A distinction can also be drawn between two popular ETFs offering exposure to the S&P 500. The ultra-popular S&P 500 SPDR (SPY) is a unit investment trust (UIT), which means it is forced to hold dividends in cash and exactly replicate the underlying index. The iShares S&P 500 Index Fund (IVV), on the other hand, can reinvest dividends from underlying securities until the distribution date, making it a potentially better play during bull markets.

The Bottom Line

Once the desired exposure has been identified, it’s worth considering the most efficient vehicle for establishing such a position. While the differences between the various options may seem minor, they can (and often do) impact the effective return realized.

By Michael Johnston of

Related Articles
  1. Stock Analysis

    3 Resilient Oil Stocks for a Down Market

    Stuck on oil? Take a look at these six stocks—three that present risk vs. three that offer some resiliency.
  2. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  3. Stock Analysis

    Is Pepsi (PEP) Still a Safe Bet?

    PepsiCo has long been known as one of the most resilient stocks throughout the broader market. Is this still the case today?
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  6. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  7. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  8. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  9. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  10. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!