Exchange traded notes (ETNs) and exchange traded funds (ETFs) may sound similar, and to some extent they are, but there are some very key differences that all investors should understand.

ETNs in many cases cover areas of the market that ETFs are unable to reach as easily – examples include the iPath MSCI India ETN (NYSEArca: INP), which existed before ETF providers launched their own India ETFs. The ETN gave exposure to a country that is notoriously suspicious of outsiders and has tight controls on foreign investment.

ETNs are backed by the creditworthiness of their issuer. In exchange for access to untouched areas of the markets comes the risk of default. Will McClatchy for ETF Zone reports that ETN investors are compensated for this extra credit risk, about 2% to 5% additional, depending on the issuer and the overall economic climate.

It’s worth noting that overnight bankruptcies, such as those witnessed in 2008, are rare. Generally an issuer goes through a series of credit downgrades before going belly up. If that’s the case, ETNs allow investors to redeem at NAV at any point. [New Volatility Hedge ETN.]

Other highlights of ETNs include:

  • ETNs  tend to serve niche asset classes requiring specialized knowledge, which gives the retail investor a chance to play without having to take on major education.
  • One element now in ETNs’ favor is that the most reckless, highly leveraged players (Bear Stearns, Lehman Brothers) have been driven from the field.  What remains are relatively more stable, conservative players such as Barclays and Deutsche Bank.
  • ETNs are free to negotiate private futures or options contracts with mining firms or traders and avoid becoming a target of the CFTC, the way commodity-focused ETFs have. [All About MLP ETFs and ETNs.]

Tisha Guerrero contributed to this article.

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.