Investors may notice that exchange traded offerings come in two wrappers: exchange traded funds and exchange traded notes.
Both ETFs and ETNs trade on an exchange and are designed to track an underlying asset; however, that is where the similarities end. Knowing the nuances between the two structures can help investors make an informed decision on which structure is a better fit for their portfolios.
The first ETF was launched in 1993, whereas ETNs did not exist until 2006, when Barclays Bank developed the structure to make it easier for retail investors to invest in hard-to-access instruments, particularly within commodities and currencies.
ETNs are senior, unsecured debt securities issued by a bank that, unlike ETFs, do not own the underlying assets that their return tracks. The return of an ETN is linked to a market index or other benchmark, and in its essence, an ETN is just a promise from a bank to pay a pattern of returns.
An ETN will pay at maturity the full value of the index, minus the management fee, completely eliminating tracking error, which can be a concern with ETFs (although it’s generally insignificant).
ETNs do not pay any dividend or interest rate payments to investors because they do not hold any portfolio securities, which means that ETN investors are not subject to short-term capital gains taxes like many dividend-paying ETFs and mutual fund investors.
The investor, however, is on the hook for a long-term capital gains tax when they sell the ETN.
On the other hand, when you invest in an ETF, you are investing in a fund that holds the assets it tracks. The investor is purchasing ownership of a basket and its contents, not piecemeal ownership of the individual contents. The savings come from trading costs and initial capital that you would need to invest in single stocks.
The last point for consideration is the importance of liquidity. ETFs have the liquidity that comes with a single stock. ETNs are a debt obligation, so credit risk is a concern that investors need to consider.
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