ETN, ETF, what is the difference and why should investors care?
Most investors have heard of an ETF – Exchange Traded Fund – as they have become extremely popular over the last decade. Used as an alternative to mutual funds they are comprised of a basket of stocks, trade like a stock on an exchange, and have lower management fees than a traditional mutual fund. An ETN stands for Exchange Traded Note and it is slightly different.
Dave from TradingMarkets explains:
ETNs are a structured products created as a senior debt note by the issuing banks. In simple language, this means that the ETN is dependent on the credit of the underlying bank. Therein lays the first design difference. ETFs represent a stake in the actual underlying product and are not subject to the same credit risk. For the investor, there is more risk in ETNs due to the above and actual market risk. ETFs, on the other hand, are subject only to market risk. Although, ETNs are issued by major, top rated banks, if their credit rating is cut, it will negatively affect the ETN regardless of the underlying market move.
In the current environment of surprising negative bank news occuring almost daily, this is becoming a critical factor in choosing to invest in ETNs. On a more positive note, ETN track the underlying product/indexes exactly unlike ETFs. The reasoning behind this is a bit odd, but makes sense if you think about it. ETNs are guaranteed to track the underlying product tic for tic by the issuing bank. They replicate the performance exactly; wherein ETFs often have limits imposed making an exact replica impossible.
Of course, the exact tracking is minus the management fee imposed by the ETN. The management fee is the only payment or distribution in the ETN, which brings us to the next difference — Taxes. ETFs are subject to make yearly capital gain and income distributions which are taxable events for the holder. ETNs do not make these distributions so the investor can defer taxation until the ETN is sold or matures.
In a sense, the ETN is more like a bond, and ETFs are more like stocks. If you are confident in the long term viability of the issuing bank, ETNs offer advantages not found in ETFs.
To summarize the above in a few quick key points:
- ETNs are tied to the credit of the bank they represent whereas ETFs are subject only to the risk of the market.
- ETNs are more risky than ETFs for the above reason.
- ETNs track the product/index exactly (less fees) unlike ETFs which are subject to market manipulation.
- ETNs are more links bonds; ETFs are more like stocks.
And there you have it, the ETN vs ETF difference.
ETNs vs ETFs – Which Fits You Best?
Dave Goodboy, TradingMarkets
Yahoo Finance, February 2nd, 2009, 8:07 am EST