ETN vs ETF: What's the Difference?

ETN vs ETF: What's the Difference?

We explain how ETNs work and how they compare to ETFs.

kent
|
Research Lead
Reviewed by: etf.com Staff
,
Edited by: Ron Day

 

You know about ETFs, but what exactly are ETNs, and how do they compare to ETFs?  

Although their names are similar, there are significant differences between ETFs and their ETN relatives.  

Find out how ETNs work and what you need to know before adding them to your portfolio. 

What Is an ETN? 

ETN stands for exchange-traded note, which is a debt note issued by a financial institution, usually a bank. Like a bond, an ETN can be bought by an investor and held to maturity, or it may also be sold in the secondary market to another investor for a market price.  

The return of an ETN is linked to a benchmark asset or to a market index. What makes ETNs relatively unique in the investment world is that they may be linked to a range of assets or benchmarks. For example, there are ETNs that track commodities, and there are ETNs that combine stock and bond positions with options, which would be difficult to package into a traditional ETF

Furthermore, ETNs are like zero-coupon bonds in that they pay no coupon (interest). In many cases, ETN investors don’t pay any tax while holding an ETN, unless they sell shares at a profit, and they owe capital gains tax. This makes ETNs more tax-efficient than traditional ETFs. 

Investors should keep in mind that ETNs can carry credit risk because they work like bonds that are underwritten by a financial institution. In an extreme circumstance, such as bankruptcy, and the issuing company is not able to make good on its promise to pay, investors could be left holding a worthless investment. 

ETNs vs ETFs: What’s the Difference? 

ETNs and ETFs are both exchange-traded securities that track the performance of an underlying benchmark index or asset, but that’s where the primary similarities end. The main difference between ETNs and ETFs is what’s inside the package, which may then lead to other differences. 

The differences between ETNs and ETFs are: 

  • Structure: An ETN is an unsecured debt instrument and can indirectly track an index or asset with forward contracts. However, most ETFs directly own the securities in the index they track. 
  • Tax treatment: Unlike most ETFs, ETNs do not pay interest or dividends, so they don’t generate taxable income while holding them. An ETN investor is only subject to capital gains tax when selling shares at a profit.  
  • Types of market risk: Since ETNs are debt instruments issued by an underwriter, there is credit risk involved, that is not associated with most ETFs. In an extreme case, the issuer could go bankrupt, rendering an ETN worthless. ETNs can also carry significant liquidity risk because they are often thinly traded, causing wide spreads between the bid and ask price. 
  • Tracking benchmark performance: An ETN issuer will typically use futures, options, and other instruments to achieve returns and promises to pay the full value of its benchmark index. Thus, there is no tracking error with ETNs; however, some ETFs can fail to track their benchmark closely. 

The Pros and Cons of ETNs vs ETFs 

ETNs have potential benefits, such as tax advantages, that are not offered by ETFs. However, there are also various types of market risk associated with ETNs that investors need to consider before investing.  

Pros of Investing in an ETN vs ETF 

  • Tax advantages: Since ETNs don’t hold the securities they are tracking, there are no dividends, interest, or capital gains passed on to the investor while they are holding an ETN. 
  • Reduced or eliminated tracking error: Since ETNs are promissory notes, the issuing company must produce the performance of the benchmark or make up the difference in performance, if there is one. This eliminates tracking error that can be associated with ETFs. 

Cons of Investing in an ETN vs ETF 

  • Multiple risks: ETNs are unsecured debt, which introduces credit risk, and an ETN can be worthless if the issuer has extreme financial problems, such as bankruptcy. Because they are often thinly traded, and thus have low trading volume, ETNs can also carry more liquidity risk than ETFs. 
  • Complexity: ETNs work like bonds, are not secured to an asset, and may use alternative investment products, such as futures, options, or stock swaps, to achieve their objective. This makes ETNs more complex, and potentially more difficult for investors to understand, compared to ETFs. 

Bottom Line 

ETNs are unsecured debt obligations issued by a financial institution, such as large banks. Like ETFs, ETNs are exchange-traded products that typically track the performance of an underlying benchmark index or asset. Compared to ETFs, ETNs can be more tax-efficient and offer less tracking error, but they are more complex and tend to carry more types of market risks. 

Kent Thune is Research Lead for etf.com, focusing on educational content, thought leadership, content management and search engine optimization. Before joining etf.com, he wrote for numerous investment websites, including Seeking Alpha and Kiplinger. 

 

Kent holds a Master of Business Administration (MBA) degree and is a practicing Certified Financial Planner (CFP®) with 25 years of experience managing investments, guiding clients through some of the worst economic and market environments in U.S. history. He has also served as an adjunct professor, teaching classes for The College of Charleston and Trident Technical College on the topics of retirement planning, business finance, and entrepreneurship. 

 

Kent founded a registered investment advisory firm in 2006 and is based in Hilton Head Island, SC, where he lives with his wife and two sons. Outside of work, Kent enjoys spending time with his family, playing guitar, and working on his philosophy book, which he plans to publish in the coming year.