ETFs vs. ETNs: How They Differ

Key differences between exchange traded funds (ETFs) and exchange traded notes (ETNs) can significantly impact overall returns, meaning one could be a better choice than the other for certain investments, says Michael Johnston of ETFdb.com.

When discussing the universe of exchange traded products now available, many investors group a number of securities under the ETF umbrella, including exchange traded notes (ETNs), grantor trusts, holding company depository receipts, and others.

While these securities are similar in many ways, there are some structural complexities that can potentially impact returns and shouldn't be overlooked.

Perhaps the most important distinction to make is between exchange traded funds (ETFs) and exchange traded notes. Although these securities are often lumped together as ETFs, they offer exposure to the related asset class in very different ways.

ETFs maintain a portfolio that corresponds to an underlying benchmark. For example, the Russell 1000 Index Fund (IWB) holds equity securities that correspond to the Russell 1000 index. ETNs, on the other hand, are debt securities issued by a financial institution that pay a return linked to the performance of an underlying index.

In other words, ETNs don't actually hold the assets that comprise the underlying index, and are instead promissory notes that pay returns based on the change in a reference benchmark.

ETNs offer investors both advantages and disadvantages. On the positive side, these securities eliminate tracking error that can plague ETFs. Because ETNs are debt instruments linked to an index, there isn't actually an underlying basket of securities that can deviate from the benchmark. Moreover, achieving commodity exposure through ETNs may offer enhanced tax efficiency relative to otherwise similar exposure achieved through funds that invest in futures contracts.

The drawbacks of ETNs are primarily related to the credit risk to which investors are exposed. Because these products are debt securities, there exists the potential for investors to be left holding the bag if the financial institution behind the ETN goes under.

While some investors write off the possibility that firms like Barclays or UBS, two banks that have issued billions of dollars worth of exchange traded notes, will go bankrupt, it's important to be aware of this risk.

Lehman Bros. serves as a cautionary tale; the bank was an issuer of ETNs at the time of its collapse. In some cases, ETNs can be less efficient from a tax perspective since distributions are taxed as interest income.

Holding company depository receipts, or HOLDRS, are also often grouped in with ETFs. But these products, offered by Merrill Lynch, are unique in more ways than one. HOLDRS have a unique structure when it comes to voting rights, and there can be unwanted tax ramifications when component companies are acquired.

Moreover, HOLDRS are subject to significant concentration of assets among just a few stocks, which can make them vulnerable to company-specific developments.

NEXT PAGE: Structure Matters

Structure Matters
Even among ETFs, there are some subtle structural differences that can impact the returns delivered by various products. For example, Rydex, WisdomTree, and iPath all offer exchange traded products designed to reflect movements in the value of the euro relative to the US dollar.

The three products aren't identical, however. The iPath EURO/USD Exchange Rate ETN (ERO) is structured as an exchange traded note, the Currency Shares Euro Trust (FXE) is a grantor trust, and the WisdomTree Dreyfus Euro Fund (EU) is an actively managed ETF.

Those distinctions may not mean much to most investors, but the different structures can lead to unique tax treatments, dispersion of counterparty risk, and ultimately, bottom-line returns.

A distinction can also be drawn between two popular ETFs offering exposure to the S&P 500. The ultra-popular S&P 500 SPDR (SPY) is a unit investment trust (UIT), which means it is forced to hold dividends in cash and exactly replicate the underlying index. The iShares S&P 500 Index Fund (IVV), on the other hand, can reinvest dividends from underlying securities until the distribution date, making it a potentially better play during bull markets.

The Bottom Line
Once the desired exposure has been identified, it's worth considering the most efficient vehicle for establishing such a position. While the differences between the various options may seem minor, they can (and often do) impact the effective return realized.

By Michael Johnston, Co-Founder and Senior Analyst, ETFdb.com