Exchange notes (ETNs) are close relatives to exchange-traded funds (ETFs), but there are some key structural differences.
For investors interested in exploring this kind of investment, we will explain how they work when it comes to investing in the index, and compare them with ETFs. (See also: Introduction to Exchange Funds.)
ETN vs ETF
ETNs are structured products issued as senior debt instruments, while ETFs are a share in the underlying product.
ETNs are more like bonds because they are unsecured. ETFs provide an investment in a fund that stores assets that it monitors, such as stocks, bonds, or gold.
Barclays Bank PLC, a 300-year-old financial institution with hundreds of millions of assets and a good credit rating from Standard & Poor’s, provides its ETN with fairly reliable support.
But even with such confidence, investments are not free of credit risk. Despite its reputation, Barclays will never be as safe as the central bank, as we have witnessed the fall of large banks such as Lehman Brothers and Bear Stearns during the recent financial crisis. Even stricter rules, requiring more security capital, do not make banks completely safe from collapse.
Differences in tax processing
ETNs track their benchmark indices minus the annual expense of 75 basis points per year. Unlike ETFs, ETNs do not have tracking errors.
Investors should consider ETNs as prepaid contracts. This means that any difference between a sale and a purchase will be classified as capital gains. In comparison, commodity-based ETFs will be derived from interest on treasury bills, short-term capital gains from the calculation of futures contracts, and long-term capital gains.
Since long-term capital appreciation is considered more favorably than short-term capital appreciation and interest, tax processing of ETNs should be more favorable than taxation of ETFs.
However, the owner of the ETN will have income taxes on interest or coupon payments issued by the ETN. For international investors, differences are compounded as related to these capital gains and will be treated differently in their home countries. (See also: Capital Gains Tax 101.)
Outside the tax regime, the difference between ETNs and ETFs comes down to credit and tracking risks.
ETNs have credit risk, so if Barclays goes bankrupt, investors may have to side with larger lenders and not get their promised return. ETFs, on the other hand, have virtually no credit risk. But there is a tracking risk associated with conducting an ETF. In other words, there is a chance that ETF returns will differ from its underlying index.
Which is better for you?
Now that you have a better understanding of the differences between ETNs and ETFs, which one to choose? To some extent, this will be determined by your tax scale and the horizon of your investment time.
While the greatest benefit to ETNs is that all gains are seen as capital gains, this gain is also delayed until the security is sold or matured. This is something that should not be taken by frivolous and long-term investors. With ETFs, capital gains and losses are realized as each futures contract spills over into another.
The big difference between ETNs and ETFs is between credit risk and tax treatment.
While the advantage of active management is controversial, there is no doubt about the value that financial engineering has brought to financial markets, as deregulation strengthened in the early 1970s. Financial engineering has made our markets more liquid and more efficient. Creating an ETN is a development that all investors should study and consider adding to their portfolios.