Back to top

ETF Education

ETFs vs. ETNs; What's The Difference?

 ZacksTrade Now

This page is temporarily not available.  Please check later as it should be available shortly. If you have any questions, please email customer support at support@zacks.com or call 800-767-3771 ext.  9339.

As the ETF world has grown by leaps and bounds in recent years, a variety of products have hit the market giving investors exposure to a number of sectors across the globe. While the vast majority of these products are exchange-traded funds, a few are what is known as exchange-traded notes or ETNs.

These notes are structured as senior, unsecured, unsubordinated debts issued by a major bank. These notes have a maturity date and are built to give investors exposure to various benchmarks—be it in the commodity, equity, or bond space—less investor fees.

The ETNs, however, do not actually hold any securities, instead an issuing bank promises to pay to investors the amount reflected by the index’s performance (minus fees).

While ETNs are generally similar to their ETF cousins, there are several key differences that investors should be aware of before deciding between the two. With that being said, it should be noted that neither method is superior in every case and that most of the differences relate to structural issues.

Nevertheless, it is still important to know how the products differ in order to better evaluate which is the best choice for a particular situation.  In light of this confusion over how these products differ, we take a look at some of the most important items that investors need to be aware of when considering a choice between ETFs and ETNs:

First, and arguably most important, is the basic structure of ETFs vs. ETNs. The exchange-traded notes are structured under the Securities Act of 1933 while ETFs are built under the rules of the Investment Company Act of 1940.

Basically, this means that ETNs are made as debt instruments while ETFs are looked at as investment companies instead. While this may seem like a small distinction, it actually is the basis for the rest of the differences between the two ETPs (read Alternative Weighting Methodologies 101).

Thanks to being debt instruments, usually unsecured debt by the issuing institution, ETNs face some level of credit risk. This means that if the issuing firm, such as UBS or JP Morgan, were to go bankrupt, investors may not receive their full investment back, if anything at all.

Furthermore, because ETNs are debt, they have a maturity date—usually about 30 years after the issuing date—when the note’s principal is then paid out to investors. ETFs on the other hand face neither of these issues; they operate in perpetuity and if an issuer of ETFs—such as iShares or PowerShares—goes belly-up, an investor’s capital is safe and secure.

For this risk, investors in ETNs do get a few key benefits that can often outweigh the credit risk involved. One of the most important is the elimination of tracking error in the basket of securities. This is because an ETN won’t actually go out and buy the securities in an index.

Instead, an ETN will promise to match the return experience of a particular benchmark, kind of like a variable rate bond. This is in stark contrast to ETFs which consist of securities that are substantially similar to an underlying index. The key word is substantially as some indexes consist of close to 10,000 securities with many being very illiquid and nearly impossible to incorporate into an easily tradable basket.

Due to this, many ETFs must pick and choose which securities are going to be in a basket, hoping to give investors an experience that is as close as possible to the underlying index and its performance. Since ETNs do not have to go out and purchase securities, they are free from these worries and have a much better time tracking an index giving investors a more realistic investment picture (see ETFs vs. Mutual Funds).

This issue also plays into another key aspect of the ETF vs. ETN debate; taxes. Since ETNs don’t actually hold any securities, they avoid the issue of having to buy and sell securities in order to rebalance the underlying basket. While this may seem like a minor issue—and generally it is—this can result in a taxable capital gain situation if a similar event happens for a holder of an ETF.

Further along this line, there is a special situation that investors should be aware of in regards to ETFs and futures contracts. This issue, which usually impacts products in the commodity space, forces ETFs that are holding futures to be structured as a partnership. This means that investors will have to fill out a K-1 at tax time, a headache that some might want to avoid if at all possible.

Fortunately, ETNs, since once again they don’t actually hold the futures, are not partnerships according to the IRS and thus investors in these products do not need to fill out a K-1 for their taxes (also see Understanding Leveraged ETFs).

Given these many benefits that ETNs have over ETFs, many investors might be wondering if they are a superior product. Unfortunately, things aren’t so clear cut as many get hung up on the issue of credit risk and for good reason given the broad concerns for banking institutions at this time.

This is especially true since Lehman Brothers used to be an issuer of ETNs giving added stigma to the space. Partially due to this fact, as well as the relative lack of transparency, the security hasn’t really caught on with the investing public. Furthermore, due to the debt structure, the funds can often times be more expensive than their ETF counterparts despite the fact that they track similar indexes.

Thanks to these factors, ETNs, pretty much across the board, trade far less frequently than their ETF counterparts. This increases the spread between the bid and the ask for these notes, pushing the total cost even higher for ETNs when compared to their ETF counterparts.

Overall, no one product is superior in every case and a close look at the key differences must be analyzed in order to come up with the best choice.  No matter what you choose, key distinctions are present across the lines of structure, tracking error, taxes, and liquidity, and these must be considered before making a selection.

For investors seeking a handy guide to the seven biggest differences between ETFs and ETNs, we have put these data points in a table below for your future reference:

Criteria

ETFs

ETNs

Credit Risk?

No

Yes

Tracking error?

Yes

No

Registration?

Investment Company Act of 1940

Securities Act of 1933

Commodity Product Tax Treatment?

Partnership, K-1 required at tax time

No special forms required

Termination?

Never

At end of note, usually 30 year period

Capital Gains?

Possible but generally unlikely

Never

Liquidity?

Ranges but usually better than ETNs

Ranges, but usually worse than ETFs

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>

Please login to Zacks.com or register to post a comment.

New to Zacks?

Start Here

Zacks Investment Research

Close

Are you a new Zacks Member or a visitor to Zacks.com?

Top Zacks Features

Learn more

Start for as little as $4.50 per trade.

My Portfolio Tracker

Is it Time to Sell?

One of the most important steps you can take today is to set up your portfolio tracker on Zacks.com. Once you do, you'll be notified of major events affecting your stocks and/or funds with daily email alerts.

More Zacks Resources

Zacks Rank Home - Evaluate your stocks and use the Zacks Rank to eliminate the losers and keep the winners.

Mutual Fund Rank Home - Evaluate your funds with the Mutual Fund Rank for both your personal and retirement funds.

Stock/Mutual Fund Screening - Find better stocks and mutual funds. The ones most likely to beat the market and provide a positive return.

My Portfolio - Track your Portfolio and find out where your stocks/mutual funds stack up with the Zacks Rank.

Zacks #1 Rank Top Movers for Zacks #1 Rank Top Movers

Company Symbol Price %Chg
LAKE SHORE G LSG 0.77 +6.05%
QUESTCOR PHA QCOR 80.07 +2.47%
VIPSHOP HOLD VIPS 156.35 +1.82%
ENLINK MIDST ENLC 36.29 +1.60%
BNC BANCORP BNCN 17.33 +1.58%