Exchange-traded funds (ETFs) are an easy and popular way to add broad exposure to a portfolio with a single trade. While the wide array of ETFs ensures that investors can find a product that fits any investment goal, there are unique offshoots of ETFs known as “exchange-traded notes” (ETNs).
ETF vs ETN
Although they trade similarly, ETFs and ETNs are very different investment products. An ETF represents a share in a bundle of assets. Depending on the specific objectives of the ETF, these assets may include stocks, bonds, or derivatives like futures and options. Investors who buy an ETF pool their money to purchase shares with specific goals, such as mimicking the performance of the S&P 500 index. On the other hand, an ETN is simply an unsecured corporate debt, and the investor does not purchase a bundle of assets.
Note: An ETF is similar to a mutual fund, while an ETN is akin to corporate bonds. However, unlike the stated interest rates that come with corporate bonds, ETN returns depend on the market performance of the tracked index or benchmark.
How Taxes Differ
ETNs have certain tax advantages over ETFs. For example, taxable dividends are typically distributed by ETFs, while this does not happen with ETNs. No gains are realized on the purchase or sale of an ETN until the actual closing transaction, which is when capital gains taxes are incurred.
Some ETNs, such as currency ETNs, are treated differently. It is best to consult a tax expert regarding any ETNs you are considering.
Avoiding Tracking Errors with ETNs
ETNs operate like pre-paid contracts, eliminating any tracking errors. The investor holding a note is promised a contracted rate of return by the issuer.
With an ETF, the funds are designed to mimic an index (without attempting to outperform it). However, this does not always happen as planned. The difference in performance between an ETF and the index it tracks is known as a “tracking error.”
Unique Risks with ETNs
ETNs and ETFs carry certain risks. The biggest risk with an ETN is credit risk. Even though the issuing bank, such as Barclays, has a high credit rating from Standard & Poor’s, that doesn’t mean it can’t make mistakes. Large banks have collapsed in the past. If something happens to the issuing bank while you hold the ETN, it may be unable to meet its obligations, and you could lose your investment.
The other potential risk is related to liquidity. There are more ETFs in the investment world than ETNs as of 2021. This reflects the relatively higher demand for ETFs, which means that trading ETN positions may not be as easy as trading ETFs.
Note: If you need to unwind or enter a position in an ETN, you may face difficulties due to low trading volume.
While the two mentioned risks are unique to ETNs, both ETFs and ETNs share the risk of market performance. For example, if an ETN aims to replicate the performance of the S&P 500, and the S&P 500 undergoes sharp losses, your ETN returns will reflect those losses. Just as with some ETFs, some ETNs are leveraged ETNs or inverse ETNs, and these investments come with additional risks.
ETNs to Watch
Before making any investment, do your due diligence and thoroughly research the investment. One way to start is to monitor ETN performance. Here are some ETNs you can keep an eye on:
- DJP: iPath Bloomberg Commodity Index Total Return ETN
- EROTF:
- iPath EUR/USD Exchange Rate ETN
- EMLBF: iPath Long Enhanced MSCI Emerging Markets Index ETN
Make sure you are carefully researching each security before making any trades. Monitor how they react to different market conditions. Understand what is present in each security, as well as what is in the underlying index or benchmark. This is very important to understand when trading leveraged ETNs and inverse ETNs, which typically involve derivatives. If you have any questions or concerns about an ETN, make sure to consult a financial professional, such as a broker, financial advisor, or financial planner.
Source: https://www.thebalancemoney.com/what-is-the-difference-between-an-etn-and-an-etf-1214785
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