ETF vs. ETN: What's the Difference?

ETF vs. ETN: An Overview

Exchange-traded funds (ETFs) have grown in been growing in popularity since their introduction in the 1990s. They generally have lower fees than mutual funds and are easier to understand since they mirror stock indexes or other benchmarks. Best of all, they can be bought and sold on exchanges, like stocks.

But ETFs have a lesser-known cousin, the exchange-traded note (ETN). It has some of the characteristics of bonds but the return on the investment is tied to an index or other indicator.

Exchange-Traded Funds (ETFs)

In practice, ETFs and ETNs are similar. Both are designed to track an underlying asset, both have lower expense ratios than actively managed mutual funds, and both trade on major exchanges like stocks.

The main difference is under the hood. When you invest in an ETF, you are investing in a fund that holds the assets it tracks. Those assets can be stocks, bonds, gold or other commodities, futures, or a mix of assets.

An ETN tracks an index, and the returns it pays out are based on the performance of that index, but it does not own the underlying assets.

Exchange Traded Notes (ETNs)

An ETN is an investment in debt, similar to a bond. It's an unsecured debt note issued by a bank.

Like an ETF, an ETN can be bought or sold on an exchange.

Just like with a bond, an ETN can be held to maturity or bought or sold at will. If the underwriter (usually a bank) were to go bankrupt, the investor risks losing the entire investment.

For that reason, anyone considering investing in an ETN needs to research the credit rating of the underwriter. If the underwriter were to receive a credit downgrade, shares of the ETN would probably experience a downturn that is unrelated to the underlying index it's tracking.

Unlike some ETFs, an ETN does not pay dividends or interest on the earnings of the underlying index, because it doesn't hold those assets and therefore doesn't receive any dividends or interest. Investors in ETNs only pay taxes on their gains when they sell the security or when it matures.

Warning: Rules change, and new rules are imposed. It's always best to talk to a tax expert before filing.

Profits and losses on ETNs are reported on IRS Schedule K-1 used to report income on pass-through entities (rather than IRS Form 1099, which is used for capital gains taxes on stocks and ETFs.)

Key Differences

ETNs have a notable advantage over ETFs given their lower tracking errors. ETFs achieve varying levels of success when tracking their respective indexes. Investors will notice some divergence from the index they track due to various factors, such as illiquid components.

Tracking error is virtually eliminated with ETNs, as the issuer agrees to pay the full value of the index (less the expense ratio) at maturity.

An ETN 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.

Tax Advantage of ETNs

ETNs have a tax advantage over other investments, including ETFs, because of the lack of taxes due on dividends and interest. A long-term investor may be significantly better off owing only the long-term capital gains due in the year the ETN is sold.

That said, ETNs are a relatively new investment vehicle and there isn't a long history of IRS treatment of special cases to rely upon. Investors in ETNs would be wise to consult a tax professional about any specific exceptions to the rules or changes in their interpretation that may affect their holdings.

Niche Access

One of the guiding principles behind ETNs is to give investors a shot at niche investing areas such as commodities, currencies, and emerging markets.

There are plenty of niche products available as ETFs as well. But the overwhelming favorite among ETF investors remains the old reliable S&P 500 Index tracking ETF.

Which Is Better?

If you follow the age-old rule that says you should invest only in what you understand, ETFs are a better choice. The ETN is a relative newcomer to the investing world, and it's complicated.

The most popular exchange-traded products are ETFs that are tied to the S&P 500 Index. They offer investors a stake in a broad range of the largest and most successful American companies.

One of the most popular ETNs is the JP Morgan Alerian MLP Index ETN (AMJ), which has an average daily volume of a little over 648,000 shares. The SPDR S&P 500 (SPY) ETF, by contrast, has an average daily volume of over 65.7 million shares.

This clearly shows that investor appetite is heavily weighted toward ETFs.

The Bottom Line

ETFs reward their investors when the underlying index or benchmark rises in value. The same goes for ETNs. An investor in either can watch their assets fluctuate in value from day to day, and can pull the trigger to sell at will.

There are differences, however. ETNs do not own the underlying assets that they track. They are bond-like instruments and their risks are tied to the health of the institution that issues them.