Financial markets are flooded with investment products that entice investors with the promise of guaranteed returns on their investments over a certain period. Among these, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) have been the popular means of growing investment portfolios.
Each of them has unique trading properties and pays returns based on the performance of the financial markets. ETNs are more like bonds in function, while ETFs behave like stocks. So, if you are thinking of investing in the financial markets but are unsure about making the right choice, look no further than this article.
What are Exchange-Traded Notes (ETNs)
Exchange-traded notes (ETNs) are unsecured debt notes or securities issued by financial institutions like investment banks with a maturity date. The reason they are called debt securities is that they do not grant investors ownership of the securities. In simpler words, an ETN does not purchase any underlying assets but tracks their performance on stock exchanges to generate returns. The issuing institution charges a management fee on these returns.
Unlike the ETF, an ETN does not trade within the funds. It leads to long-term capital gains with lower tax rates, making it a more efficient investment product for long-term investors. Having said that, investing in an ETN involves credit risk in case the issuing institution goes bankrupt. Therefore, it is advised to check the credit ratings of a financial institution before investing in an ETN.
How do Exchange-Traded Notes (ETNs) Work
As mentioned earlier, an ETN functions more or less similar to traditional bonds, which means you get a return at maturity. However, it does not pay any dividends or interest rates. Investors can trade an ETN against currencies, commodities, and futures. This ETN is then virtually linked by the issuing institution to any metric of its choice with the promise of paying returns relative to the performance of the linked metric.
An ETN provides investors with an opportunity to invest in a variety of trading instruments and get maximum returns. The return includes the investment capital, the resulting price of the index over a set period, and the commission charged by the financial institution. Furthermore, investors enjoy lower expense ratios and no costs for the underlying index of securities.
What are Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) are among the most favored investment products traded on exchanges like stocks. It owns a series of securities, including stocks, bonds, commodities, or futures, that tracks an underlying index. With this wide variety of tradable assets, investors can build diversified investment portfolios. Also, they can buy an ETF to create a pool of investment with the specific goal of making profits.
Given the lower broker commissions and expense ratios, ETFs are equivalent to mutual funds. Even so, they are more liquid compared to mutual funds, but their prices fluctuate throughout the day. In contrast with ETNs, investors receive the ownership of an underlying asset. ETFs generate returns from the interest on short-term capital gains and dividend distributions.
With ETFs offering so many benefits, it is an obvious question of why ETNs are the preferred choice among investors. Well, the answer lies in the fact that ETFs are highly liquid and come with tracking risk. It is an indication that returns can be unexpected with the ETFs.
Difference Between ETNs and ETFs
While both ETF and ETN trade on major stock exchanges and track an underlying asset, there are striking differences between them. Investors prefer one over the other considering their investment goals. The two major differences are ownership of underlying assets and tax treatment. First, an ETN does not own any underlying assets and offers tax advantages for investors. Second, an ETF owns a stake in an underlying index and incurs short-term capital gains taxes.
Pros and Cons of ETNs
|Function like bonds and pay returns on maturity||No dividends or interest rates|
|Can be traded on a major stock exchange||Higher trading prices due to low trading volume|
|No need to purchase an underlying index of securities||Market and credit risk|
|Tax benefits on long-term capital gains||Massive price fluctuations due to liquidity|
|Reduced tracking error||Contain holding-period risk|
|Access to more familiar asset classes||Fewer issuing institutions or banks|
|Can be traded throughout the day||No regular capital gains|
|No portfolio of securities||Issuing institutions can have lower credit ratings|
|Available for purchase at a very low price||Failure in tracking the underlying index can lead to certain tracking errors|
|Better option to invest in taxable accounts||Some are leveraged or inverse|
|Offer long-term investors access to less explored markets||Indirectly invest in emerging markets|
|Highly liquid than ETFs||Less in numbers|
Pros and Cons of ETFs
|Combine features of stocks and index funds||Commissions, brokerage fees, and other trading fees|
|Can be traded on major stock exchanges||Insufficient diversification|
|Cost-effective, tax-efficient, and low management fees||Smaller volume can create higher bid-ask spreads|
|Can be sold throughout the day||Subject to market risk|
|Highly liquid and less volatile||High risk of tracking error|
|Low expense ratios||Own stake in an underlying index of securities|
|Offer exposure to equities, currencies, and other assets||Incur short-term capital gains taxes|
|Regular dividends distributions||Not actively managed portfolios|
|Investors control their funds||Bundled investments restrict investors from excluding a stock|
|Can be sold through market orders, limit orders, and stop-loss orders||Do not allow reinvestment of the dividends|
|Easy to buy and sell||Returns differ from the index it tracks|
|Low minimum investment||Fluctuations in currency price can influence returns|
|Highly transparent||Less immune to the market volatility|
Are Exchange-Traded Notes (ETNs) Good Investment?
Though exchange-traded funds (ETFs) are an efficient way of earning huge returns, investors choose to trade with exchange-traded notes (ETNs) for their long-term tax advantages. In the following points, we will get to know why an ETN is the right choice for making investments compared to an ETF.
1. Tax Treatment
Since there are no interest rates or dividends on the underlying index, an ETN generates long-term capital gains. Due to this, investors get favorable tax treatment and are required to pay long-term capital gains taxes. These taxes incur when an ETN reaches maturity or is sold by the investor. It is not the case with an ETF that distributes dividends, making investors liable for paying annual taxes on short-term capital gains.
2. Reduced Tracking Error
Technically, when the difference between the performance of an ETF and its benchmark index goes beyond the expense ratio, it is termed as the tracking error. It usually happens because of an ETF’s need to rebalance their securities with the performance of underlying indices. As opposed to ETFs, ETNs do not own any underlying index of securities. They promise to pay a predetermined rate of return in any case, which results in reduced tracking errors.
3. Access to Less Explored Markets and Assets
ETN investors are able to access the markets and broad asset classes that are out of their reach. It creates immense possibilities for them to make profits from volatility and liquidity. An ETF, on the other hand, offers access to illiquid instruments like commodity futures and charges higher commissions, which drive long-term and smaller investors away from making investments.
Are Exchange-Traded Notes (ETNs) Safe?
As unsecured debt obligations, ETNs have their risks, making them less suitable for all types of investors. The most common risks inherent in an ETN include its reliance on the creditworthiness of issuing institutions and low trading activity. That said, features like significant long-term capital gains taxes, reduced active-risk, and the issuer’s promise to pay returns at maturity attract investors to ETNs.
Both ETNs and ETFs are traded on major stock exchanges and allow diversification of portfolios with investments in currencies, commodities, and emerging markets. Due to their large volume, widely diverse portfolio, and cost-effectiveness, ETFs are the premier choice among short-term investors. ETNs, on the other hand, lure long-term investors with capital gains tax benefits.
Moreover, investors consider ETFs to generate revenue from dividends or interest rates, while ETN holders gain access to illiquid assets. On the negative side, ETFs are often let down by their commissions and brokerage fees, while ETNs are infamous for carrying the credit risk.
In essence, for investors who wish to avoid paying annual taxes on capital gains and capitalize on exotic investments with promised returns, ETNs are worth considering. Since investment products are subject to market risk, we would recommend you doing your research or consulting a financial advisor to find a great fit for your investment goals.