Updated: Sep 21, 2020
Many investors will be familiar with the term ETF or Exchange Traded Funds. However, the term ETN or Exchange Traded Note is less well known. This ETNs also track the performance of an index, a sector or a region. Many investors, financial professionals included, use the term “ETF” rather loosely, covering items that may not be technically “Exchange Traded Funds”.
For investors especially those interested in ETFs, it is important to understand the ETN, know the differences between it and the ETF, and then incorporate these instruments into one’s overall investment strategy.
ETFs are financial instruments that represent a basket of asset where investors are combining funds to purchase assets for specific objective, like matching the performance of S&P500. The S&P500 index comprises of 500 companies listed on the New York Stock Exchange (NYSE) and the NASDAQ Composite, and is considered to be the best representation of the U.S. stock market.
In contracts, ETNs are unsecured corporate debt notes issued by a financial institution, e.g. corporate bank. They, like ETFs, may track an index like the S&P500, an industrial sector like Oil and Gas, a foreign currency, or some other indicator such as market volatility. ETNs can sometimes combine different securities such as equity and bond positions with option overlays, or use other strategies that are different from traditional ETFs.
In layman’s terms, an ETF may be comparable to a mutual fund, while ETN is analogous to a corporate bond. However, ETN’s differ from corporate bonds in that their returns do not depend on interest rates, but the market performance of the tracked benchmark.
An advantage of ETNs vs ETFs is that ETNs do not distribute taxable dividends, unlike ETFs. Profits incurred on the acquisitions of ETNs are usually not realised until the final actual transaction, where taxes on capital gains are incurred. As ETN’s are prepaid, there are no tracking errors since contracted rate of return is guaranteed by bank issuing the ETN. In contrast ETFs may encounter tracking errors between performance of the ETF and the index it is designed to track.
As with most investments, ETNs also have limitations as compared to ETFs.
One downside of ETN is that of credit risk. If the ETN issuing bank undergoes liquidation, the ETN can default. To mitigate this, institutional investors can redeem from the underwriter daily, in advance of any potential default. Another risk is that due to relatively higher demand for ETFs in the market, ETNs may be traded with a lot less liquidity and investors may encounter difficulty with ETNs due to reduced trading volume.
Both ETFs and ETN share market risk, reflecting the losses of the tracking index in the case of general market downturn effecting that benchmark.
Two ETFs tracking the S&PP500 Index are SPDR S&P 500 ETF (SPY) and Vanguard S&P 500 ETF (VOO) while an example of one ETN tracking market volatility is iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX).
Both ETFs and ETNs are used by different investors with different objectives. More risk averse investors would prefer ETNs due to the tax benefits and reputation of the issuing bank while other investors would prefer the flexibility and opportunities of ETFs. The market volatility tracking ETN is also traded for hedging purposes.
It is prudent for investors to conduct due diligence on the specific financial instrument before embarking on any investment or making any trades. Ensure that proper studies and research to understand the behaviour of the ETF and ETN reacting to different market scenarios and also understand the underlying benchmark or index. If any doubt, please consult a financial professional advisor.