Understanding ETF vs. ETN: Key Differences Explained

ETF vs. ETN: An Overview

Exchange-traded funds (ETFs) and Exchange-traded notes (ETNs) are popular investment options, but come with their own structures and risks. ETFs invest in physical assets like stocks or bonds, while ETNs are unsecured debt issued by financial institutions. Both track indexes or benchmarks, yet each carries unique benefits and risks. Investors can also find niche market options for both ETFs and ETNs.

Key Takeaways

• ETFs buy and hold assets in the index they track, while ETNs are unsecured debt notes issued by financial institutions.

• ETNs have no tracking error since the issuer agrees to pay the full index value at maturity.

• ETFs and ETNs can be traded like stocks on major exchanges, but differ in ownership and risk.

• ETNs carry default risk if the issuing institution fails, unlike ETFs, which own actual assets.

• ETNs offer tax advantages by not paying taxable dividends or interest, deferring taxes until sale or maturity.

Understanding Exchange-Traded Funds (ETFs)

ETFs and ETNs have similar characteristics. Both mirror the assets contained in an index or other benchmark. Both have lower expense ratios than actively managed mutual funds. And both trade on major exchanges like stocks.

When you invest in an ETF, you are investing in a fund that buys and holds the assets it tracks. If it's an S&P 500 Index, it invests its clients' money in all 500 of those stocks, in the same proportion in which they're represented in the index. It will gain (or lose) money from hour to hour in the market, just like the S&P. (There can be minor differences in the results. This is referred to as "tracking error.")

There's a huge variety of ETFs to choose from, including not just stock funds but funds that invest in bonds, gold or other commodities, futures, or a mix of assets. Many focus on a single industry or sector. In January 2024, the first bitcoin futures ETFs were added to the mix.

Exploring Exchange-Traded Notes (ETNs)

An ETN also tracks an index, and the returns it pays out are based on the performance of that index. Like an ETF, an ETN can be bought or sold on an exchange.

However, the ETN does not own the underlying assets. An ETN is an investment in debt, similar to a bond. It's an unsecured debt note issued by a bank.

Just like a bond, an ETN can be held to maturity or bought and sold at will. If the underwriter (usually a bank) were to go bankrupt, the investor risks losing the entire investment.

For that reason, anyone considering investing in an ETN needs to check the credit rating of the underwriter. If the underwriter were to receive a credit downgrade, shares of the ETN would probably experience a downturn that is unrelated to the underlying index it's tracking.

Unlike many ETFs, an ETN does not pay dividends or interest on the earnings of the underlying index to its investors. It doesn't own those assets and therefore doesn't receive any dividends or interest.

Investors in ETNs get their profits when they sell the ETN or when it matures.

They also owe taxes on the long-term gains they receive. Profits and losses on ETNs are reported on IRS Schedule K-1, used to report income on pass-through entities (rather than on IRS Form 1099, which is used for capital gains taxes on stocks and ETFs.)

Warning: Rules change, and new rules are imposed. It's always best to talk to a tax expert before filing.12

Important

Don't count out ETNs. These funds are more efficient than some ETFs and have favorable tax treatment.

Comparing Key Differences Between ETFs and ETNs

ETNs tend to have lower tracking errors than some ETFs.

These errors are caused by factors like illiquid components. Prices can simply move too fast to achieve a precise match.

Tracking error is virtually eliminated with ETNs. The issuer has agreed to pay the full value of the index (less the expense ratio) at maturity.

An ETN pays investors once the fund matures based on the price of the asset or index. There's no tracking error because the fund itself isn't actively tracking. Market forces will cause the fund to track the underlying instrument, but it's not the fund doing the tracking.

The Tax Advantages of Exchange-Traded Notes (ETNs)

ETNs have a tax advantage over many other investments, including ETFs, because they do not pay taxable dividends and interest. This is a trade-off. Some investors are better off only owing the taxes due when the ETN is sold or reaches its maturity.

That said, ETNs are a relatively new investment vehicle and there isn't a long history of IRS treatment of special cases to rely upon. Investors in ETNs would be wise to consult a tax professional about any specific exceptions to the rules or changes in their interpretation that may affect their holdings.

Accessing Niche Investments Through ETNs

One of the guiding principles behind ETNs is to give investors a shot at niche investing areas such as commodities, currencies, and emerging markets.

There are plenty of niche products available as ETFs as well. But the overwhelming favorite among ETF investors remains the old reliable S&P 500 Index tracking ETF.

Which Is Better?

If you follow the age-old rule that says you should invest only in what you understand, ETFs are a better choice. The ETN is a relative newcomer to the investing world, and it's complicated.

The most popular exchange-traded products are ETFs, especially those that are tied to the S&P 500 Index. They offer investors a stake in a broad range of the largest and most successful American companies.

One of the most popular ETNs is the JP Morgan Alerian MLP Index ETN (AMJ), which has an average daily volume of over 400,000 shares.3 The SPDRS&P 500 (SPY) ETF, by contrast, has an average daily volume of over 110 million shares.4

This clearly shows that investor appetite is heavily weighted toward ETFs.

Are ETNs a Risky Investment?

ETNs have the same risks as bonds. There is the risk of default by the issuer. In that respect, an ETN is like an unsecured bond. If the institution goes down in flames, so does your investment.

The performance of an ETN is tied to a specific index. The ETN's value fluctuates with that index. In this respect, an ETN is like an ETF.

Nevertheless, the ETN's performance can be affected from two distinct directions: the market direction of the underlying index and the fortunes of the institution that issues the ETN.5

Are ETNs Riskier Than ETFs?

Generally, ETNs are considered riskier than ETFs because they combine default risk and market risk.

An ETF can decline sharply if the market tanks, but it would take a genuine catastrophe to render it worthless. If an ETN's issuer defaults, the ETN is worthless.

Does an ETN Own the Assets in the Index?

An ETN owns nothing but an IOU. It is a promise to repay a loan after a set time period, typically 20 or 30 years. If an investor sells the IOU earlier than the maturity date, the seller receives an amount that is based on the index that the ETN tracks.

The Bottom Line

ETFs let you own a share of the underlying assets directly, while ETNs are unsecured debt instruments that track the same indexes without holding the assets. Both fluctuate in value and can be sold at any time. ETNs carry credit risk, as their value depends on the financial health of the issuing institution. Both investments have different tax advantages and tracking accuracy, making it important to understand these distinctions before investing.