Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs) are popular investment vehicles that trade on stock exchanges. While they may seem similar at first glance, their underlying structures, risk profiles, and tax implications differ significantly.
These differences make ETFs and ETNs suitable for distinct types of investors based on their financial goals and risk tolerance.
Before getting into these differences, let’s first understand what ETFs and ETNs are, their structures, and how they function in the investment domain.
Understanding the Basics of ETFs and ETNs
What is an ETF?
An Exchange-Traded Fund (ETF) is a pooled investment vehicle that holds a diversified portfolio of assets, such as stocks, bonds, or commodities. ETFs are designed to track the performance of a specific index, like the S&P 500 or NASDAQ-100, by holding the same underlying securities in similar proportions.
When you invest in an ETF, you own shares of the fund, which represents a fractional interest in the underlying assets. For example, if an ETF tracks the S&P 500, it will hold shares of all 500 companies in the index, allowing investors to gain broad market exposure through a single investment.
Key Features of ETFs:
- Transparency: ETFs disclose their holdings daily, offering investors a clear view of the underlying assets.
- Liquidity: ETFs are traded on stock exchanges, making them easy to buy and sell throughout the trading day.
- Income Potential: Many ETFs pay dividends or interest based on the income generated by the underlying assets.
What is an ETN?
An Exchange-Traded Note (ETN) is a debt instrument issued by a financial institution. Unlike ETFs, ETNs do not hold any physical assets. Instead, they are designed to deliver returns based on the performance of a specific index or asset, minus fees.
When you invest in an ETN, you are essentially lending money to the issuer (such as a bank) and relying on their ability to meet their financial obligations. ETNs track their designated index precisely, as there is no need to manage or replicate an actual portfolio of assets.
Key Features of ETNs:
- Credit Risk: As unsecured debt, ETNs carry the risk of issuer default. If the issuer goes bankrupt, investors may lose their principal investment and any expected returns.
- Tax Efficiency: ETNs typically do not pay dividends or interest, which allows for tax deferral until the note is sold or matures.
- Precision: ETNs eliminate tracking errors, ensuring that their performance closely mirrors the target index.
ETF vs. ETN: The Main Differences
Exchange-Traded Notes (ETNs) and Exchange-Traded Funds (ETFs) are both exchange-traded investment products, but they differ significantly in structure, risk, and tax treatment.
Let’s discuss these differences to understand how each works and what makes them suitable for different types of investors.
Structural Differences
The primary distinction lies in how ETFs and ETNs are constructed.
- ETFs: These are investment funds that hold a collection of assets like stocks, bonds, or commodities. When you invest in an ETF, you own a small piece of the fund, which directly holds the underlying securities.
For example, if an ETF tracks the S&P 500, it holds shares of the 500 companies in that index, mirroring its performance.
- ETNs: In contrast, ETNs are unsecured debt instruments issued by financial institutions. They do not hold any physical assets. Instead, they are contractual obligations from the issuer to pay investors returns based on the performance of a specific index, minus fees.
Essentially, investing in an ETN means you’re lending money to the issuer (like a bank) and relying on their promise to pay the returns of the index.
Risk Profile
The risk associated with ETFs and ETNs varies because of their differing structures.
- ETFs:
ETFs carry tracking risk, which occurs when the fund’s returns differ slightly from the performance of its underlying index. This divergence can happen due to management fees, trading costs, or inefficiencies in replicating the index.
However, ETFs have virtually no credit risk because they directly hold the assets they track. Even if the ETF issuer faces financial difficulties, the fund’s assets remain protected as they are held separately from the issuer’s liabilities.
- ETNs:
ETNs, on the other hand, do not carry tracking risk since they are designed to precisely match the performance of the index they follow. However, they expose investors to credit risk, which means that if the issuing institution defaults or declares bankruptcy, investors may lose their principal and expected returns.
For instance, during the 2008 financial crisis, major banks like Lehman Brothers collapsed, highlighting the real possibility of credit risk even for well-established financial institutions. ETN investors must carefully assess the creditworthiness of the issuer before investing.
Tax Treatment
Tax implications for ETFs and ETNs are another key area where these products differ, influencing the after-tax returns for investors.
- ETFs:
ETFs generally distribute income from dividends, interest, or capital gains to investors. These distributions are taxable in the year they are received, even if the investor reinvests them. For long-term holders, this can result in annual tax liabilities that reduce overall returns.
Additionally, when an ETF is sold, any gains are subject to capital gains tax. The type of tax (short-term or long-term) depends on how long the investor held the ETF.
- ETNs:
ETNs are taxed differently. Since they don’t hold underlying assets or pay dividends, investors don’t face annual tax liabilities on distributions. Instead, gains are taxed only when the ETN is sold or matures. This deferral can be advantageous for long-term investors, especially those in higher tax brackets, as it allows their investments to grow tax-free until the sale.
However, the tax treatment can vary depending on the ETN’s design and the investor’s country of residence. International investors may face additional complexities in how their ETN gains are treated.
Income Generation
Another difference lies in how these products handle income.
- ETFs:
Since ETFs hold assets like stocks or bonds, they can generate regular income in the form of dividends (for equity-based ETFs) or interest payments (for bond-based ETFs). This makes ETFs attractive to income-focused investors, such as retirees seeking steady payouts. - ETNs:
ETNs do not hold physical assets and therefore do not generate dividends or interest payments. Instead, investors benefit solely from the capital appreciation of the index being tracked. This lack of income generation can make ETNs less appealing for those looking for regular payouts but more suitable for those focused on growth.
Liquidity and Trading
Both ETFs and ETNs trade on exchanges like stocks, but their liquidity and trading dynamics can differ.
- ETFs:
The liquidity of an ETF depends on both the trading volume of the ETF itself and the liquidity of its underlying assets. Highly traded ETFs with liquid underlying securities tend to have smaller bid-ask spreads, making them more cost-efficient to trade. However, ETFs with less liquid underlying assets may experience wider spreads and greater price fluctuations. - ETNs:
ETN liquidity depends on the issuer’s ability to maintain sufficient supply in the market. Because ETNs don’t hold assets, they rely on the issuer to issue or redeem notes to meet market demand. While this can sometimes result in tighter tracking of the index, it also means ETNs might face liquidity challenges during times of market stress or if the issuer withdraws support.
Who Should Invest in ETFs or ETNs?
- ETFs are better suited for:
- Investors seeking transparency and low credit risk.
- Those who value income generation through dividends or interest.
- Short- and long-term investors who want easy access to diversified funds.
- ETNs are ideal for:
- Tax-conscious investors who prefer deferring taxes until sale or maturity.
- Those focused on precise index tracking without worrying about tracking errors.
- Long-term investors with confidence in the issuer’s creditworthiness.
Example: Comparing ETFs and ETNs
Imagine two investors tracking the same index:
- Investor A chooses an ETF. They receive regular dividend payouts but face annual taxes on these gains.
- Investor B opts for an ETN. They don’t receive payouts but benefit from deferring taxes until they sell.
If Investor B holds their ETN long-term in a stable market, they may save on taxes compared to Investor A.
Note: Exchange-Traded Notes (ETNs) are considered non-compliant with Shariah principles. As such, Musaffa neither encourages nor recommends investing in ETNs.
Bottom Line
To wrap things up, understanding the differences between ETFs and ETNs can help you make informed investment decisions that align with your financial objectives.
Whether you prioritize low credit risk, income generation, or tax efficiency, selecting the right product depends on your individual needs and market outlook.
Remember, while ETFs offer transparency and income potential, ETNs can provide precise index tracking and tax deferral benefits—but with added credit risk. Take the time to assess your risk tolerance and the credibility of issuers before investing.
With the right approach, both ETFs and ETNs can serve as valuable tools for building a well-diversified portfolio.
Disclaimer: This content is for informational purposes only and does not constitute financial advice. Please research or consult a financial advisor before making any investment decisions. Information is accurate as of the publication date but may not reflect recent changes. Access our comprehensive legal disclaimers at Musaffa.com/disclaimer.