Exchange traded funds and exchange traded notes seem to get lumped together when it comes to investing. While the titles sound similar, there are very distinct features of both that are unique to each tool.
An exchange traded note is a debt instrument or bond, that does not invest in an asset but tracks an index or benchmark. They are not derived from equities and they are more similar to bonds than index funds, reports John Waggoner for USA Today. An ETF is an investment in many stocks at once like a mutual fund, that trades like a single stock. The performance of an ETF is linked to an index or benchmark, like an ETN. [Comparing ETFs and ETNs]
ETFs and ETNs carry different risk attributes but fulfill the same basic function. ETNs can be more secure than ETFs because of the debt structure but will carry similar credit risks as bonds. ETFs carry similar market risks as stocks and mutual funds.
An ETN’s biggest risk factor is that it doesn’t own anything rather, they are a promise to pay a return. The strength is in the provider that is issuing the note. The note can be vulnerable if the issuer gets into financial trouble, otherwise known as a default. With an ETN, an investor can lose some of all of their investment is the ETN issuer goes bankrupt. [Key Differences Between ETFS and ETNs]
ETNs do give investors a leg up on taxation issues. “For the time being, investors in ETNs enjoy advantageous tax treatment–gains are subject to taxes only when the investor sells the note and, then, only at the 15% long-term capital gains rate. In comparison, 60% of any gains in commodity ETFs are subject to the long-term capital gains rate while 40% are subject to the more-punitive short-term rate, irrespective of holding period–also known as the 60/40 rule,” Abraham Bailin wrote for Morningstar.
ETFs are independent entities in which the underlying assets are held by a separate custodial institution. ETFs are protected from any financial risk that the issuing company may carry. In the rare event that an ETF issuer implodes, the ETF’s assets won’t go down with the entire ship. Instead, a new manager will take over the affected ETF, or the portfolio will be liquidated and the market value of the proceeds distributed to shareholders. [Investors Warned on ETN Risks]
Tisha Guerrero contributed to this article.