While the names of both these financial instruments seem similar, there are significant differences between them. Let’s explore both of these and understand the differences between the two.
What are ETFs?
Exchange-traded funds (ETFs) are one of the most popular financial instruments that combine the flexibility of stocks with the diversification of mutual funds. The financial company that offers ETFs purchases a basket of assets—stocks or bonds, currencies or commodity futures contracts—that comprise the fund. The ETF is designed to follow an index or a collection of assets.
While purchasing the investors don’t own the actual asset or security. The ownership of securities is with the companies offering these funds. Today there is a wide variety of ETFs that covers a huge variety of assets.
Characteristics of ETFs
- Long-term investment – ETF is suitable for long-term investment because it has a low cost of ownership
- Easy to understand price movement – Since an ETF is linked to the performance of a specific index, the movement of the price of an ETF is also fairly easy to understand.
- Buy and Sell at any time – Investors can buy and sell ETFs at any time during the trading hours on the exchange.
What are ETNs?
An exchange-traded note (ETN) is a loan instrument issued by a financial entity, such as a bank. It comes with a set maturity period, usually from 10 to 30 years. It can be traded based on demand and supply. Exchange-traded notes do not produce any interest revenue for the lender. The gains or losses of the investor are derived from the performance of an asset class or index that it tracks. The investor may opt to sell the ETN before its maturity or keep it until maturity to get its returns.
Exchange-traded notes (ETNs) are issued by an underwriting bank, and their return is based on the performance of a stock index. When the exchange-traded note (ETN) matures, the financial institution offers the investor cash in an amount that reflects the underlying index’s performance.
Characteristics of ETNS
- Asset ownership – The investor does not own the underlying assets the ETN tracks.
- Unsecured debt – The investor has to trust the issuer about the performance of the fund. It can be judged by the creditworthiness of the issuing financial institution. During the issuance of the exchange-traded note, the issuer does not provide any collateral that can be exchanged to cover the losses suffered by the investor.
- The liquidity offered – Exchange-traded notes (ETNs) can be traded on trading days through the exchange or directly with the issuing bank.
- Expense ratio – Exchange-traded notes (ETNs have an annual fee the fund manager charges for covering the management of the fund and other expenses.
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The Difference between ETFs and ETN
While the name sounds similar, both these financial instruments have some major differences:
ETFs are like purchasing a stock. Investors can easily trade them during trade hours. Whereas, ETNs are debt instruments that come with their credit risk. They come with a maturity date. However, if investors choose to sell sooner, they can sell on the open market.
When investors hold an ETN until the maturity date, they receive a one-time payment based on the performance of the underlying asset, index, or strategy.
ETFs, offer diversified portfolios of stocks to investors. A single purchase gives them the power to hold multiple stocks. This includes equities, bonds, and commodities. Whereas, ETNs are not an investment in funds they are debt instruments. They are backed by the creditworthiness of the issuer.
The tax treatment of ETFs and ETNs is different. With ETNs, investors are taxed only upon sale. Short-term capital gains rates apply if held for less than one year; long-term capital gains rates apply if held for more than one year.
As for ETFs, they could be a little trickier, especially when it comes to commodity ETFs that hold futures and leveraged funds. Therefore, always do your homework regarding applicable taxes.
ETNs have no tracking error; this can be very attractive to some investors. However, tracking error has not been a big problem with ETFs.
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The Similarities between ETFs and ETNs
ETFs and ETNs both track an underlying asset and trade like stocks. Traders can buy, sell and sell short these instruments through online and direct access trading platforms just as they would a short. Most ETFs and ETNs trade on the majority of stock exchanges.
The Pros and Cons of ETFs
Below are listed the Pros and Cons of investing in ETFs:
Pros:
- ETFs offer exposure to a variety of asset classes. Some ETFs track stock market indexes, and bond market indexes amongst others
- ETFs are liquid, as liquid as individual stocks. They can be easily traded throughout the day during trade hours
- ETFs are passively managed investments. As a result, their fee is also very low. Also, they have a comparatively lower expense ratio than mutual funds. The expense ratio is the percentage of the value of the ETF that is taken from the fund every year to cover management expenses. ETFs offer low trading fees and a low investment as compared to stock and mutual funds.
Cons:
Here are some drawbacks associated with ETFs:
- Tax liability is huge. ETFs distribute dividends, interest, and capital gains. Therefore, when an investor purchases shares of an ETF they will pay short-term capital gains tax on the proceeds if they sell in less than one year. Long-term capital gains tax applies if an investor’s holding period is greater than one year.
- ETFs are subject to two major risks:
- Market risk: Market risk is the risk of market volatility. The value of the ETF declines when the index falls.
- Tracking risk: Tracking risk is based on tracking errors. Tracking error is the difference between the value of the market index the ETF is tracking and the index fund.
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The Pros and Cons of ETNs
Pros:
- ETNs can be easily traded on the stock exchange
- They give access to difficult-to-reach markets like foreign currencies, new markets
- ETNs can be redeemed at maturity for the value of the market index.
- If an investor wants, he can sell it before the maturity date
- ETNs are like zero-coupon bonds and pay no interest or dividends during their lifetime. So, they have preferential tax treatment when compared to ETFs.
- If an ETN is sold at maturity or before and the sales price is greater than the price of the market index, the investor makes a profit.
Cons:
Some of the drawbacks of investment in ETNs are:
- One of the biggest risks which investors are exposed to is credit risk. Since they are debt securities issued by a financial institution, the credit rating of that institution has a huge influence. If its credit rating is downgraded, the ETN could lose value even though the market index it is tracking has not changed.
- Exposure to substantial risk: The market for the ETN is not yet robust. They have liquidity issues. Because there may not be enough buyers. Therefore, if a buyer wants to buy an ETN, they may have to pay a premium.
- ETNs also have default risk. If the financial institution, backing the ETNs defaults, owners can do nothing. External factors like political or regulatory changes contribute to default risk.
- In case the financial institution chooses to call the ETNs before maturity, then there is redemption, or call, risk. In addition to it, if the sale price is lower than the purchase price, the investor takes a loss.
Some of the popular ETN issuers are:
- Bear Stearns
- Lehman Brothers
- Morgan Stanley
- UBS
- Barclays Bank
- Goldman Sachs
- Credit Suisse
- BNP Pariba
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List of Popular ETFS
| Sr. | Symbol | Name | Avg Daily Share Volume (3mo) | AUM |
| 1 | TQQQ | ProShares UltraPro QQQ | 186,283,234 | $ 12,266,200 |
| 2 | SQQQ | ProShares UltraPro Short QQQ | 121,571,820 | $ 5,353,580 |
| 3 | SOXL | Direxion Daily Semiconductor Bull 3x Shares | 94,920,344 | $ 4,413,890 |
| 4 | SPY | SPDR S&P 500 ETF Trust | 79,955,195 | $ 364,609,000 |
| 5 | LABU | Direxion Daily S&P Biotech Bull 3x Shares | 53,013,367 | $ 895,134 |
| 6 | QQQ | Invesco QQQ Trust | 50,413,379 | $ 156,723,000 |
| 7 | XLF | Financial Select Sector SPDR Fund | 40,280,344 | $ 33,614,800 |
| 8 | EEM | iShares MSCI Emerging Markets ETF | 39,810,363 | $ 25,061,400 |
| 9 | FXI | iShares China Large-Cap ETF | 39,709,738 | $ 5,729,910 |
| 10 | UVXY | ProShares Ultra VIX Short-Term Futures ETF | 38,144,574 | $ 590,065 |
List of Popular ETNS
| Sr. | Symbol | Name | Inception Date | Market Cap |
| 1 | AMJ | JPMorgan Alerian MLP ETN | 04/02/2009 | $ 417,219,063,269 |
| 2 | FLYD | Bank of Montreal MicroSectors Travel -3x Inverse Leveraged ETN | 06/22/2022 | $ 71,185,260,933 |
| 3 | FLYU | Bank of Montreal MicroSectors Travel 3x Leveraged ETN | 06/22/2022 | $ 71,185,260,933 |
| 4 | WTID | Bank Of Montreal MicroSectors Energy 3X Inverse Leveraged ETNs | 02/15/2023 | $ 71,185,260,933 |
| 5 | WTIU | Bank Of Montreal MicroSectors Energy 3X Leveraged ETNs | 02/15/2023 | $ 71,185,260,933 |
| 6 | VXX | iPath Series B S&P 500 VIX Short-Term Futures ETN | 05/02/2019 | $ 632,416,224 |
| 7 | VXZ | iPath Series B S&P 500 VIX Mid-Term Futures ETN | 05/02/2019 | $ 64,507,906 |
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Which is better? ETFs or ETNs
ETFs may be better than ETNs in many circumstances. But this is eventually decided when it comes down to risk and the type of investor.
ETFs are a popular type of security. They have been around for a very long time. ETFs are offered by nearly every broker and it gives a regular payout not only for seasoned investors but also for newbies. But there are additional taxes that the investor has to pay due to dividends and extra regular payout.
ETFs are a good investment for investors:
- Who prefer their investments about which they have good information and can understand easily.
- Investors who prefer a range of choices before deciding their suitable investment option.
- Investors don’t mind paying the additional taxes that come with extra payout in the form of dividends.
ETNs can be valuable if investors are looking for a niche area of the market that’s not covered by ETFs. Also, there are not many options out there. So, finding the right option is a hassle. However, ETNs are subjected to more risks.
ETNs are good for investors:
- Who prefers a specific niche that ETNs offer
- Want to avoid taxes
- Can run the extra mile in terms of research and available options for investments
- Don’t mind the additional risks: credit risk, default risk, and call risk
Both these financial instruments have their own set of target audience. Therefore, claiming one is better than the other is not a fair judgment. Everyone is the best judge for their investments. Because eventually, it comes down to what the investor prefers and wants!
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