Exchange traded notes (ETNs) are often referred to as the cousin of exchange traded funds (ETFs). Like ETFs, they trade all day on exchanges, tout low fees and give access to challenging areas of the market. But they differ in some important ways.

What Are ETNs?

ETNs are debt instruments backed by the full faith and credit of the issuer. They follow an underlying index or product and anyone can buy them. Since they are debt, if the issuer goes bankrupt, you become another creditor and you’ll have to get in line.

ETNs exist in far fewer numbers than ETFs, and they have attracted about 1% of the assets held in ETFs. One factor that could explain their lesser popularity is the risk associated with investing in them. ETNs are essentially debt instruments, meaning that if the issuing bank goes under, you’ll have to get in line with other creditors for your money. [Differences Between ETFs and ETNs.]

Here are some of the primary differences between ETFs and ETNs:

  • ETFs have the liquidity that comes with a single stock. ETNs are a debt obligation, so credit risk is a concern investors need to be mindful of.
  • ETFs offer instant diversification because when you purchase one, you invest in a fund that buys and holds multiple assets. This includes, equities, bonds, and commodities. ETNs are not investments in funds; instead, you are buying debt from the issuer and they are backed by the full faith and credit of the issuer.
  • ETNs have maturity dates. When you hold an ETN until the maturity date, you receive a one-time payment based on the performance of the underlying asset, index or strategy. If you wish to sell sooner, you can sell on the open market.
  • When you buy an ETF, you buy ownership of a basket and its contents, not piecemeal ownership of the individual contents. The savings come from trading costs and initial capital that you would need to invest in single stocks.
  • The tax treatment of ETFs and ETNs is different. With ETNs, you are taxed only upon sale. Short-term capital gains rates apply if held for less than one year; long-term capital gains rates apply if held for more than one year. As for ETFs, they could be a little trickier, especially when it comes to commodity ETFs that hold futures and leveraged funds. Doing homework on this is necessary. (There’s more on ETNs and taxes down below).
  • Both ETFs and ETNs give access to hard-to-reach markets, such as currencies and certain foreign markets. One example of the benefits of ETNs is the iPath MSCI India ETN (INP), which gave investors the ability to gain exposure to a rapidly growing economy before the India ETFs came along.
  • ETNs have no tracking error; this can be very attractive to some investors. However, tracking error has not been a terribly big problem with ETFs.
  • ETNs don’t make interest or dividend payments, and they don’t offer principal protection. No voting rights come with owning ETNs.

What Are Their Advantages?

Despite the risk, though, ETNs do have some big advantages that could make them appealing to investors, Karan Damato for The Wall Street Journal says. These include:

  • Favorable tax treatment for investors seeking commodities exposure. Many commodity ETFs buy futures contracts. Under tax rules, in most futures owe tax on any appreciation each year, even if they don’t sell. Sixty percent of any gain is taxed as a long-term capital gain; 40% is taxed as a short-term gain, at ordinary-income rates. For ETNs, gains are taxed only upon sale, and gains on commodity ETNs held longer than a year are considered long-term, currently subject to a maximum 15% tax rate. The IRS hasn’t specifically addressed the tax treatment of the notes, though, so this could change. Consult your tax professional for advice.
  • Unlike traditional mutual funds, both types of exchange-traded products can be bought and sold all day long like individual stocks.
  • There’s fairly low credit-risk on notes from larger banks, such as Barclays or Deutsche Bank.

ETNs and Taxes

You may be familiar with the ETF creation and redemption process, which warrants some discussion before we move onto the ETN creation and redemption process:

  • The creation process of an ETF begins with a prospective ETF manager, or sponsor, filing a plan with the Securities and Exchange Commission (SEC) to create an ETF.
  • Once approved, the sponsor forms an agreement with an authorized participant (AP) – market maker, specialist or large institutional investor – who is able to create or redeem ETF shares.
  • The authorized participant then borrows shares of stock and places them in a trust to form creation units of the ETF.
  • The trust provides shares of the ETF that represent legal claims on the shares held in the ETF. The transaction is an in-kind trade where securities are traded for securities, which means no tax implications, since there was no cash changing hands.
  • Finally, the AP receives the ETF shares, and the shares are then sold to the public as stocks in the open market.

With ETNs, there’s no need for shares to be created or change hands. If more shares are needed, the index provider quotes a net asset value (NAV) and a deal is worked out with the custodian.

ETNs are only taxed upon sale of the fund under normal capital gains rates.  Paul Justice of Morningstar takes it a step further and outlines these helpful basic ETN tax rules (these go for ETNs other than for currency tracking funds):

  • They generally holds no real assets
  • You are taxed only upon sale
  • Short-term capital gains rates are applied if held for less than one year
  • Long-term capital gains rates are applied if held for more than one year
  • They typically do not generate interest or dividend income

As always, we’re not accountants, so consult your accountant for current tax advice.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.