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Happy ETN investorSince exchange-traded funds (ETFs) and exchange-traded notes (ETNs) have become popular investments, there is an ongoing discussion about the pros and cons of investing in an ETN vs. ETF. Both are investments that help an investor diversify their portfolio. Each has definite pros and cons associated with it. They differ in many ways and each has specific risks that an investor should consider before investing. Speak to a financial advisor to find out if an ETN or ETF is right for you to use to diversify your portfolio.

What Is an ETF? An ETN?

An ETF is a basket of financial assets that are traded on a stock exchange. They trade throughout the day just like stocks. ETFs track a market index. Some ETFs are baskets of stocks that track the broad market through the Standard and Poor’s 500 index. Those ETFs are composed of all 500 stocks in the index. Other ETFs may track a narrow sector of the market like the technology sector or a foreign market index. There are ETFs for alternative investments, like gold or currencies, as well as for specific market sectors. They have some similarities to mutual funds.

An ETN is different in composition than an ETF. ETFs are baskets of underlying securities put together by the fund developers. ETNs are senior debt securities that are unsecured and issued by a financial institution. ETNs resemble zero-coupon bonds since they have no coupon payment during the life of the ETN. If you hold the ETN until maturity, you receive the market value minus management fees.

Both ETFs and ETNs trade on a stock exchange. They both track a market index. Both the ETF and ETN have prices that fluctuate with the market index they are tracking.

Pros of an ETF

ETFs are investments that offer investors exposure to most classifications of financial assets. Some ETFs track stock market indexes, bond market indexes and others. They offer the same liquidity that you have when buying and selling stock, but their trading costs are lower than for stock. Consider an ETF that tracks a broad market index like the Standard and Poor’s 500. All 500 stocks are in the basket of stocks that form the ETF. If you were going to individually buy each of the 500 stocks, your investment in all 500 would be prohibitively large and so would your total cost of making those 500 trades.

Even though ETFs resemble mutual funds, they are more liquid than mutual funds. ETFs can be traded during the hours the market is open and not just at the end of the day like mutual funds.

ETFs usually have passive management, which also lowers the management fees when compared to the mutual funds that are actively managed. Passive management also means fewer capital gain distributions.

ETFs often have lower expense ratios 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. Some stock brokerages have even dropped charging a commission on ETFs.

ETFs do offer some diversification of your portfolio depending on the type of EFT you have. For example, if your ETF tracks the Standard and Poor 500 market index, you have exposure to every market sector and industry. But, if your ETF is composed of gold mining stocks and tracks a gold index, you don’t have as much diversification since the market sector is narrow.

Cons of ETFs

ETF picture

The ETF sounds like the perfect investment for those who don’t want to invest in individual securities, but there are some drawbacks associated with them. They make distributions of dividends, interest and capital gains. If you hold an ETF in a taxable account, you will pay short-term capital gains tax on your proceeds if you sell in less than one year. Long-term capital gains tax applies if your holding period is greater than one year. ETFs also pay dividends and interest, depending on the type of securities in the ETF.

Both are subject to the tax you pay on ordinary income. Another con is that there is no reinvestment of dividends available for ETFs. The tax treatment of ETFs is perhaps their biggest drawback.

ETFs are subject to primarily two types of risk: market risk and tracking risk. Market risk is the risk of market volatility. If you have an ETF that is tracking a broad market index, chances are that it will fall in value if the market declines. Tracking risk is based on tracking error. Tracking error is the difference between the value of the market index your ETF is tracking and the index fund.

Pros of ETNs

The ETN is a newer financial investment than the ETF. It is an unsecured debt instrument issued, usually, by large banks and other financial institutions. Like the ETF, ETNs trade on a stock exchange, using a traditional brokerage and track the performance of an underlying market index. They were developed to give investors access to important and exotic securities, such as currencies, along with possible new markets, like foreign markets.

ETNs can be redeemed at maturity for the value of the market index. They can also be sold in the open market before maturity. At the time they are redeemed or sold, the investor will pay long-term capital gains tax if they have been held for one year or more. Short-term capital gains tax is only applicable if they have been held for less than one year. 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 of ETNs

ETNs have exposure to substantial risk. Since the market for the ETN is not yet robust, they have liquidity risk. There may not be enough buyers of ETNs, so they have liquidity risk if the investor wants to sell. If a buyer wants to buy an ETN, they may have to pay a premium.

ETNs also have default risk. If the financial institution, like a large bank, issues ETNs and then is unable to pay back the principal at maturity, they could default on their obligation. Owners have little recourse if this happens. Outside factors like political or regulatory changes contribute to default risk.

If the financial institution chooses to call their ETNs before maturity, then there is redemption, or call, risk. In this case, if the sale price is lower than the purchase price, the investor takes a loss.

ETNs occasionally differ from the index it is tracking in terms of value. This is called tracking risk. If there is a significant difference at maturity, the investor could take a loss. Some ETNs even use a proprietary market index which may increase tracking risk.

The most significant risk ETNs have is credit risk. Since they are debt securities issued by a financial institution, they are impacted by the credit rating of that institution. If its credit rating is downgraded, the ETN could lose value even though the market index it is tracking has not changed.

The Bottom Line

Trading software window on PC screenETFs are baskets of securities bundled and tracked against a market index. ETFs suffer from the tax regime they have to follow. ETNs are debt instruments issued by financial institutions. They also track a market index, but they are much more like bonds even though they don’t pay interest. The market for ETNs can be illiquid since they have not reached the popularity of ETFs. ETNs also carry a credit risk.

Tips on Investing

  • Consider working with a financial advisor as you consider what types of funds are most appropriate for your goals, timeline and risk profile. Finding one doesn’t have to be hard. SmartAsset’s matching tool can connect you to several financial advisors in your area within minutes. If you’re ready, get started now.
  • Use the SmartAsset capital gains calculator to help determine your tax position.

Photo credit: ©iStock.com/fizkes, ©iStock.com/1001Love, ©iStock.com/G0d4ather

Rosemary Carlson
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