Yahoo Finance The Difference Between ETFs and ETNs
In the exchange-traded product market, the ever-popular ETF remains king. But there's a related but less-widely used investment vehicle called an exchange-traded note that could prove valuable for some investors to sprinkle sparingly into their portfolios.
Both trade on public exchanges like regular stocks. But exchange-traded funds hold assets, such as baskets of stocks mirroring an index that the fund tracks. ETNs are debt, essentially promises by an issuing bank to pay a return linked to the performance of an index. Those promises are backed by an issuing bank's credit. ETNs have a maturity date, or investors can sell them like a stock if they want an earlier payout.
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There are about 203 exchange-traded notes with $23.2 billion in assets under management in the U.S., compared with nearly 1,700 ETFs with $2.2 trillion in assets under management, according to Invest With An Edge, which tracks exchange-traded products.
ETNs are riskier than ETFs, investing experts say, mainly because they add credit risk that ETFs don't. In other words, if a bank collapses, like Lehman Brothers did in 2008, ETN investors probably would be out of luck.
That presents ETN investors with both a securities risk, since the notes track a certain index, and a credit risk, as the notes do not own an underlying asset and the potential payment to investors is a promise from the issuing bank, says Sean O'Hara, president of PacerETFs Distributors, a division of Paoli, Pennsylvania-based Pacer Financial.
"If they go bankrupt you lose," says Vern Sumnicht, CEO of iSectors, an ETF investment strategist in Appleton, Wisconsin.
In addition to being right about the direction of the underlying index, "now I have to be right about the underlying bank that's issuing the note," Sumnicht says. "A lot of investors that don't understand them would be afraid of them."
But both say there are times when ETNs are actually the best option for certain types of investments -- commodities, for instance.
Over the past two decades, both ETFs and ETNs have opened commodities investing to everyday investors, Sumnicht says. Aside from owning extractive companies and the risks associated with them, everyday investors generally didn't have exposure to commodities because of how complicated it was to buy futures contracts, for example.
Now, exchange-traded products offer unleveraged exposure to investors interested in commodities in a liquid and understandable investment vehicle, Sumnicht says.
[Read: 8 Investments Riskier Than Vegas.]
Investors would want ETFs in their portfolio for equity and fixed income-based products, but ETNs make sense for exposure to commodities because of potential taxable income, O'Hara says.
ETFs that track commodities often use futures contracts to own the underlying commodities. That mean owners of those ETFs are going to get hit with a special tax form called a K1, which are "kind of nasty," Sumnicht says. ETFs of master limited partnerships can also face K1 exposure. ETFs that are backed by precious metals held in vaults are taxed as collectibles.
Exchange-traded notes avoid some of these tax headaches, namely the dreaded K-1 form, Sumnicht says. Also, with ETNs, investors aren't taxed on dividends that are in the index, only on the return from the ETN when it is sold or reaches maturity, O'Hara says.
Sumnicht's iSectors has one ETN in its portfolio -- Elements Rogers International Commodity Total Return ETN -- because it offers the best cost benefit for a broad commodities allocation, Sumnicht says. It tracks a well-diversified index, is not overweight in energy and is issued by the Swedish Export Credit Corp., a bank that Sumnicht says is solid.
But, he says if there were a way to own the same thing through an ETF, he probably would.
Another advantage to ETNs is that they don't have the tracking error problem that can afflict ETFs, Sumnicht says, because they are notes tied to an index, rather than funds buying actual assets.
O'Hara also adds currency into what potentially could be advisable ETN investments as they could be more tax efficient and easier to buy than derivatives, such as futures that are used to get exposure to the currency markets.
[Read: 4 Types of REITs for Investors.]
But Sumnicht says ETFs are better vehicles for currencies because they don't have to use futures markets for exposure; they can just own the currencies outright.
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