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 ETFdb.com

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: Vanguard Total World Stock

    Learn about the Vanguard Total World Stock exchange-traded fund, which invests in stocks located in numerous countries with a high level of diversification.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  3. Mutual Funds & ETFs

    ETF Analysis: BioShares Biotechnology Products

    Learn more about the BioShares Biotechnology Products fund, an exchange-traded fund that is focused on producers of FDA-approved drugs.
  4. Mutual Funds & ETFs

    ETF Analysis: SPDR EURO STOXX 50

    Learn about FEZ, the Euro Stoxx 50 ETF. FEZ tracks the 50 largest companies in Europe, making it the Dow Jones Industrial Average of Europe.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraShort Nasdaq Biotech

    Learn more about an innovative inverse-leveraged sector exchange-traded fund, or ETF, the ProShares UltraShort Nasdaq Biotechnology fund.
  6. Chart Advisor

    Value Stocks Offer Stability in a Volatile Market

    With volatility on the rise, investors are turning to segments of strength such as value stocks. We'll take a look at several ETFs that could be worth a closer look.
  7. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  8. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  9. Mutual Funds & ETFs

    ETF Analysis: Market Vectors EM High Yield Bd

    Learn more about the Market Vectors Emerging Markets High Yield Bond ETF, a fund dedicated to subinvestment grade foreign debt issues.
  10. Mutual Funds & ETFs

    ETF Analysis: First Trust Tactical High Yield

    Find out more about the First Trust Tactical High Yield fund, a debt security-focused ETF designed to produce high income.
RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  3. Fractal Markets Hypothesis (FMH)

    An alternative investment theory to Efficient Market Hypothesis ...
  4. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  5. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  6. Lion economies

    A nickname given to Africa's growing economies.
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  6. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
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!