Exchange-traded funds or ETFs, have become one of the most popular trading and investing tools on Wall Street. According to research firm ETFGI, there was nearly $4.6 trillion invested in ETFs as of November 2017. But while you may be familiar with ETFs, you may not be quite as familiar with their sister product—exchange-traded notes or ETNs.
ETFs are funds that buy and hold the assets they track, such as stocks, bonds or commodities. ETNs, on the other hand, are unsecured senior debt notes issued by financial institutions. In other words, ETFs are closer in design to stocks, while ETNs are closer to bonds.
If you consider the bond-like construction of ETNs, it becomes clear that the financial health of the ETN underwriter is very important. Not only do ETNs trade in line with the value of their underlying assets, they also trade in line with the credit risk of the underwriting institution.
This is the key difference and primary risk of ETNs. If the issuer of an ETN goes under or sees their credit rating downgraded, that could mean the ETN’s holders won’t get paid.
Just like ETFs, ETNs can also be structured to provide leveraged returns (though the same risks that apply to leveraged ETFs apply to leveraged ETNs).
ETNs are generally considered more tax efficient than ETFs because they don’t hold individual securities. Therefore, taxable events, such as dividend payments, are eliminated entirely.
While ETFs are typically structured as regulatory investment companies, ETNs are typically considered to be prepaid forward contracts. In that respect, gains or losses on most ETNs are only taxed as capital gains when you sell your shares.
Whether or not the structure of ETNs is better than that of ETFs is really a matter of personal preference. In some cases, you can choose between the two structures.
For example, one of the most popular crude oil funds out there is the United States Oil Fund (USO), which is designed to track the price of WTI crude oil futures. However, there are also crude oil ETNs, such as the iPath S&P GSCI Crude Oil Total Return Index (OIL), which is designed to track the price of WTI crude oil as measured by the underlying S&P index. OIL is underwritten by Barclays, so any payment to shareholders is reliant on Barclays’ ability to satisfy its financial obligations.
As always, the most important factor in any investment is making sure you understand what you are buying, how it works and the risks involved before you buy.
It is highly recommended that any trader or investor who is considering trading ETFs or ETNs, whether leveraged or not, should read this information furnished by the SEC: https://www.sec.gov/investor/alerts/etfs.pdf
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