ETFs vs ETNs

What are exchange-traded notes (ETNs)?

An ETN stands for “exchange-traded note”. Much like ETFs, ETNs trade on a stock exchange, and they also track an underlying index or asset to determine their value.

However, unlike ETFs, ETNs are a type of debt security, in a similar way to a corporate bond. They are issued by a financial institution (often a bank) and essentially represent a promise to pay investors the return on an index or asset on a fixed maturity date.

The financial institution does not have to own the instrument themselves, but rather can use your invested money in whatever way they please, perhaps investing it in a range of other assets to generate a return.

ETN investors then receive their initial investment back plus any returns on the index or asset at the maturity date, minus any associated management fee.

As this means ETN investors are taking on debt when they purchase them, there’s credit risk involved with ETN investing – indeed, were the issuer to fail, you’d lose your entire investment.

ETNs will rise and fall in value over time, depending on how the underlying index or asset performs. So, investors can trade them on stock exchanges for varying values, depending on what they think the note will be worth at maturity – hence them being “exchange-traded” products.

You can purchase various types of ETNs, including:

• Index ETNs, tracking a stock market index such as the FTSE 100 or S&P 500
• Industry ETNs, tracking a specific sector such as technology or fossil fuels
• Currency ETNs, tracking the value of specific currencies
• Market volatility, essentially speculating on what will happen in a market in future.

Is an ETF a good investment?

ETFs clearly have a range of benefits that can potentially make them a good investment. While there may be the risk of a tracking error and they may be more expensive than individual stocks due to management fees, they are easy to understand and give you access to a range of assets with a single investment.

Before you decide to invest, you should first consider deciding on your personal investment objectives – that is, what do you actually hope to achieve with your investing? Are you looking to provide yourself with an income now or create a pot for later in life, perhaps even retirement?

This will help you make more informed decisions as to whether ETFs suit your needs.

Pros of trading ETFs

• A highly accessible way to invest in multiple assets at once

As an ETF is essentially a basket of other investments, they allow you to gain exposure to a wide range of underlying assets in a single investment.

Additionally, they are highly accessible and easy for investors of all levels to understand. Indeed, most retail investors will likely have heard of ETFs, which they may not have done with ETNs.

• Suitable for long-term investors

As they contain a range of other assets that will rise and fall in value over time, ETFs are typically suitable for long-term investing.

• Attractive trading costs

While a handful of them do have fund managers, the majority of ETFs are passively managed. That means ETFs typically have lower management fees to pay on your fund units.

Cons of trading ETFs

• Risk of tracking errors

A “tracking error” is when there is a difference between the value of the assets in the ETF and the value of the benchmark it’s supposed to track.

ETFs are prone to tracking errors, which may see you generate less of a return than you might have been expecting.

• Costs may be higher than buying individual stocks and shares

The lower management fees associated with ETFs against other mutual funds often make them seem more appealing. However, if you wanted to invest in certain individual stocks, it might be most cost-effective for you to buy them directly rather than purchasing through a fund.

Also consider: Investment Trust vs ETF: where should I invest?

Pros of trading ETNs

• Access to a wide range of underlying assets

As the issuing bank or institution doesn’t need to own the asset for you to purchase an ETN, they can offer them on a wide range of indices and markets.

This means you can access a wide range of markets, many of which may not even have ETFs that offer the same.

• No risk of tracking errors

Unlike ETFs, there’s no risk of a tracking error with an ETN. Instead, the issuer has made an irrevocable promise to pay the return of the index or underlying assets at maturity.

• Favourable tax treatment

ETNs tend to be treated favourably in terms of tax, whereas you may be liable for certain taxes with an ETF.

For example, an ETF might pay out taxable dividends to investors. Meanwhile, an ETN will not. So, while you won’t benefit from dividends or interest income, there might be less tax to pay over the course of holding the investment.

Indeed, you’ll typically only be liable for Capital Gains Tax (CGT) on any rises in value when the ETN matures.

• Suitable for short-term investing

Like a bond, an ETN has a maturity date. This may make them a more suitable option for short-term holding.

Cons of trading ETNs

• Tend to carry greater risk

Arguably the biggest downside of an ETN is the additional risk they can present.

These are unsecured debt instruments. So, if the issuing bank fails, you’d lose your entire investment. This is unlike what would happen if an ETF were to fail, in that your assets would simply be liquidated at their current market value.

It may seem an unlikely scenario for an ETN issuer like a bank to fail. But even the American banking giant Lehman Brothers went bankrupt in 2008 in the wake of the financial crisis. No institution is ever too big to go under.

As a result, you’re presented with both market risk and credit risk when trading ETNs.

• You don’t own the underlying asset

You must remember that you have no claim to the underlying commodity, index, or any other asset that the ETN tracks. As a result, you have no right to own it, even if you hold an ETN for an asset that performs well or beats the market.

• Can be illiquid

ETNs don’t always have high trading volume and so can be illiquid. This may make them difficult for you to sell.

Always check the trading volume of any ETNs you are considering before you buy.

Is an ETN a good investment?

An ETN can be a good investment if you’re confident that you know how they work and you’re comfortable with the additional risk that you’re taking on.

The better question is simply where ETNs fit into your investment strategy. If you’re looking for an investment with a fixed maturity date that might help you reach a short-term goal, or you want to diversify your portfolio with assets that won’t be available to you elsewhere, then these could be effective assets.

Of course, as I have mentioned, make sure you do your research and that you’re comfortable with the credit risk associated with debt instruments like these.

Should I invest in ETFs or ETNs?

Having read all about these two options, you may be wondering which exchange-traded product is the most suitable investment decision for you.

While neither is inherently better than the other, there are two major elements to consider when choosing between the two:

1. What is your investment time frame?
2. Do you fully understand how ETNs work?

The value of your fund units in ETFs tend to fluctuate in line with market conditions, as the value of the underlying assets will rise and fall over time. As a result, these funds tend to be more suitable for long-term holds.

Meanwhile, ETNs have a fixed maturity date in a similar way to a bond. This means they are likely only going to be suitable in the short term.

Crucially, ETNs are highly specialised and generally more difficult to understand than ETFs. It’s often not sensible to invest in an asset class that you don’t fully understand, so you may want to stick with ETFs until you have a firm grasp on how ETNs work and the additional risk they may present.

Of course, all investing involves risk and you could lose your entire investment no matter which option you choose.

Always do your due diligence on any investment products you’re considering adding to your portfolio. And, if you’re unsure whether they’re suitable for you, make sure you speak to an independent expert, such as a financial advisor or financial planner.