Many investors have become quite familiar with ETFs over the past few years, as more are beginning to see the benefits of the exchange-traded structure. Now close to 1,500 different products are in the American market, while well over one trillion dollars is invested in the space.
Yet while many might have a good understanding of ETFs, most investors probably haven’t grasped the nuances of Exchange-Traded Funds’ cousin, ETNs. These products, short for ‘Exchange-Traded Note’, are pretty similar to ETFs though there are a few key differences to be aware of between the two (also see ETFs vs. ETNs: What’s The Difference?).
First, it is very important to note that ETNs are debt instruments of an issuing financial company. They are senior, unsecured and unsubordinated, and thus take on the credit risk of their issuer.
While this does result in a bit of risk, investors should note that the security type doesn’t actually hold the underlying stocks, bonds, or commodities, and instead promises to pay investors an amount equal to the index’s performance, minus fees.
ETNs also have a maturity date as well, since they are debt instruments, while ETFs do not have the issue. In this same vein, ETNs are often callable before the maturity date, though when this happens the principal is paid back (read ETF Investors: Beware the Coming ETN Backlash).
Upsides to ETNs
While this may sound like a lot of downsides, there are several good reasons to prefer an ETN structure. First, since the securities do not hold anything, they do not have tracking error as they can easily follow a benchmark.
The lack of trading back and forth also allows for more complex and higher volume strategies which may be inappropriate for an ETF. Lastly, the lack of trades also prevents a number of tax issues as well, making ETNs (generally speaking) more tax efficient than their ETF counterparts (also read A Primer on ETF Investing).
For more on the key differences between the two types of products, see our short video on the subject below:
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