ETF vs. ETN: An Overview

Exchange-traded funds (ETFs) have gained ground on mutual funds with their often-lower fee structure and easier-to-understand stock-like price action. But ETFs have a not-so-well-known cousin—the exchange-traded note (ETN). ETNs are something that many retail investors may not know about. It's time to shed some light on the ETN and decide if this product has a place in your portfolio.

Key Takeaways

  • Both ETFs and ETNs are designed to track an underlying asset.
  • When you invest in an ETF, you are investing in a fund that holds the asset it tracks.
  • An ETN is more like a bond. It's an unsecured debt note issued by an institution.

Exchange-Traded Funds (ETFs)

In practice, ETFs and ETNs 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 stocks.

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

Exchange Traded Notes (ETNs)

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 or 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 does not pay dividends or interest income (unlike some ETFs) there are no yearly taxes due. Investors of ETNs only pay capital gains taxes when they sell the security.

Don't count out ETNs. These funds are more efficient than some ETFs and have favorable tax treatment.

Key Differences

ETNs have a notable advantage over ETFs given lower tracking errors. ETFs achieve varying levels of success when tracking their respective indexes. Investors will notice some amount of 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). 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 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 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 the research and gained an appropriate level of understanding with which to make that determination.