As more investors delve into the world of exchange traded funds, some may find exchange traded note options. However, ETNs are not ETFs and potential investors should understand the difference.
Similar to index-based ETFs, ETNs also track some sort of index as part of their investment strategy. However, an exchange traded note, like the name implies, is a type of debt note that trades on an exchange.
“The chief difference between an ETF and an ETN is that the ETF owns the stocks and bonds that make up the portfolio, while the ETN is merely a note that pays the return on the portfolio,” Joseph LaCorte, president of S-Network Global Indexes Inc., told USA News.
Due to their structure, ETNs may have some upsides that ETFs don’t enjoy. For instance, ETNs can easily create leverage, or return two or three times the daily return of an index.
ETNs may more closely track their underlying index. Additionally, in the case of commodity investments, ETN investors would not have to deal with a K-1 form that an investor would with a comparable futures-based ETF.
Additionally, since ETNs are technically a debt security, their distributions are taxed at ordinary income rates, like any taxable bond.
However, there are caveats that ETN investors should be aware of. ETNs are debt securities issued by financial institutions that promise to pay the return of an index, minus fees and taxes. Therefore, investors are exposed to the credit risk or the possibility the underwriting bank goes bankrupt. 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 or all of their investment if the ETN issuer goes under.
“As a result, the investor assumes the credit risk of the issuer of the note,” LaCorte added. “Most issuers of ETNs are large banks, so this credit risk is minimal. But investors should always keep in mind that when they buy an ETN, they are buying a bank note, not stocks and bonds.”
While current ETN issuers like Barclays and Credit Suisse are robust banks, investors should not completely write off the risks. Lemhan’s Brothers filed for bankruptcy in 2008, which dragged down its Opta ETNs as well.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.