Exchange traded funds and exchange traded notes give investors asset allocation with targeted sector exposure. The choices that are available range from asset classes, commodities, currencies, sectors and bonds. Both funds and notes have launched that focus on the same areas, giving investors plenty of choices.
First, an investor should decide if an ETF or an ETN is their tool of choice. A fund tracks an index, or basket of stocks, and invests in equities or futures. A note, on the other hand, is a debt instrument, and the provider is responsible for the debt. An ETN can give investors specific exposure that a fund can not, with favorable tax treatment but credit risk that are inherent with notes can be unfavorable. [Key Differences Between ETFs and ETNs]
However, an ETN can offer benefits to an investor, and tracking error is not a problem when it comes to notes. [ETF Spotlight: Coffee]
“One solution to those problems (tracking error) is the ETN, or exchange-traded note, a relatively new product that combines characteristics of bonds and ETFs. It offers intraday trading, is theoretically immune to tracking error, and provides access to asset classes that are otherwise difficult for average investors to buy,” Chris Gay for US News reports.
As for ETFs, a study conducted by State Street Global Advisors at the Wharton School of Business concluded that 67% of investment professionals characterized ETFs as the most innovative investment vehicle introduced in the last decade. Another 60% stated that ETFs had “fundamentally changed the way they constructed investment portfolios”, reports Investing Daily on MinyanVille. [Investors Warned on ETN Risks]
On average, ETNs cost investors about 0.83% compared to ETFs that cost 0.57% on average, according to Lipper data. ETNs can beat ETFS when it comes to tax treatment. There are no periodic income or capital distributions, and gains are treated as capital gains, which can carry a low 15 % federal tax rate for holdings of more than one year. The treatment is subject to regulatory changes with the IRS, so be sure to double check these in the note prospectus.
An ETN is not going to outperform an index the same way an active ETF can. The note is promise to pay back what the index is doing, minus a management fee. So long as the provider remains healthy, a note can be predictable, although ETNs do have credit risks that ETFs avoid. [Key Differences Between ETFs and ETNs]
Tisha Guerrero contributed to this article.