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But why are ETFs so much more popular than ETNs? Read on to find out the key differences between the two and why you may want to invest in one over the other.

What is an exchange-traded fund (ETF)?

Exchange-traded funds (ETFs) have become very popular in recent years. An ETF is a type of security that holds underlying investments like stocks or bonds. They are traded on stock exchanges much like stocks. An ETF is a pooled, managed investment much like a mutual fund. For example, many of the ETFs offered by Vanguard are actually structured as another share class of their mutual funds.

Many ETFs follow indexes like the S&P 500, the Russell 2000, and other stock and bond market indexes. In this way, they are similar to index funds. One of the largest ETFs is the Vanguard Total Stock Market Index (ticker VTI). It tracks the CRSP US Total Market Index. And that index seeks to track the total U.S. stock market. Another example is the SPY, which tracks the S&P 500.

More: Learn how to invest in ETFs

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What is an exchange-traded note (ETN)?

Exchange-traded notes are similar to ETFs in that they are traded on the exchange. But ETNs hold unsecured debt issued by a bank or other financial institution. It's important to remember that these are first and foremost debt instruments. Anyone considering investing in an ETN must understand the creditworthiness of the institution backing the ETN.

Some ETNs track the return of an index like the S&P 500 but don't own the underlying stocks in the index. ETNs are often tied to benchmarks for currencies, commodities, silver, or gold. However, the financial institution that issued the debt is ultimately responsible for paying the ETN holder at the time of maturity. ETNs pay no dividends or interest. The return is a combination of any change in the underlying index and changes in the price of the debt instrument.

ETN vs. ETF: key differences

When you invest in ETFs you are investing in the ETF's underlying portfolio. This could be the stocks that make up a popular index like the S&P 500 or bonds such as those in the Bloomberg Barclays US Aggregate Bond Index.

ETNs on the other hand are debt instruments issued by a financial institution. While their performance may be tied to an index tracking an asset like stocks, commodities, or currencies, at the end of the day if the financial institution behind the ETN has financial problems, ETN holders could see the value of their notes reduced or wiped out altogether.

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Differences in tax treatment

ETFs can be taxed in several ways.

  • Any distributions paid to an ETF are taxed. This could be in the form of dividends, interest, or capital gains. If the ETF is held in a taxable account, you will be subject to taxes on these distributions based on the appropriate tax treatment for that type of distribution.
  • When shares of the ETF are sold, any gain is subject to taxation. It can be at either the long-term or short-term capital gains rate. The difference depends upon the holding period for the shares. Or in the case of a loss, that loss can be used to offset other gains, other income up to the limit allowed or carried forward to a subsequent year if needed.

More: Tax-efficient investing: which investment types are the most recommended ones?

ETNs on the other hand don't hold any securities. That means they pay no distributions that are subject to taxes. When the ETN is sold, if there is a gain on the sale of the security, this gain could be short-term or long-term.

An exception to this is currency ETNs. All gains on these ETNs are taxed as ordinary income, regardless of the holding period. A loss on the sale of an ETN is treated the same as a loss on the sale of an ETF.

You pay no tax in the current year if an ETF or ETN is held inside of a traditional or Roth retirement account.

Difference in risks

ETFs and ETNs expose investors to different risks.

The risk inherent when investing in an ETF is generally tied to the risks associated with the security's underlying holdings. These could be the risks associated with stocks should the market decline or with bonds when prevailing interest rates rise. If the stock market drops, the value of an ETF that tracks a stock market index will likely decline. The same can be said when interest rates rise regarding the likely impact on an ETF that tracks a bond market index.

In some cases, ETFs can experience tracking errors. This occurs when an ETF's performance diverges significantly from the index. This generally doesn't occur in an ETF that tracks a widely traded index like the S&P 500.

ETNs are essentially credit instruments of the issuing financial institution and as such are subject to credit risk should the issuer run into financial difficulties. Also, ETNs are still subject to the market risk of the underlying index they follow.

Some investors saw the credit risk aspect of ETNs firsthand during the financial crisis. Lehman Brothers had three ETNs outstanding at the time of their bankruptcy. Investors who held any of these securities spent more than a decade trying to get back just a fraction of their investment.

Investors in ETNs need to understand that these are debt instruments regardless of the underlying index, commodity, or currency benchmark tracked.

Which is better, ETF or ETN?

Whether an ETF or ETN is better will vary from investor to investor. However, it's important to understand the potential benefits and risks of both types of exchange-traded securities when deciding where to invest.

For investors looking to track more conventional areas of the market such as stocks and bonds, ETFs could be the better choice. ETFs are essentially investments that are tied to an asset class like stocks or bonds. This makes ETFs very much a core holding asset for most investors. Many investors build all or most of their portfolios via the use of ETFs.

The default risk inherent in an ETN makes ETNs a fringe holding for most investors. It could be very risky to build an entire portfolio of ETNs.

Comparing these two exchange-traded vehicles is very much a comparison of apples to oranges. Both are delicious fruits but are distinctly different. ETFs and ETNs are exchange-traded investments, but that's largely where the similarities end.

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About the Author

Roger Wohlner

Roger Wohlner

Freelance Contributor

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments.

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