ETNs vs ETFs - Which Fits You Best?

Posted 06/22/2009, 9:00 am EST by David Goodboy from TradingMarkets.com

A relative newcomer to the world of exchange traded products, Exchange Traded Notes (ETNs) were first created by Barclay's in 2006 and have become an interesting alternative to Exchange Traded Funds (ETFs).

ETFs and ETNs are very similar in the fact that they both trade on an exchange like a stock, follow an underlying product and are easily accessible to investors. However, they differ remarkably in the way they are designed. This article will explain the differences between ETNs and ETFs as well as provide examples of ETNs so that you can choose which exchange traded product fits your investment criteria.

ETNs are issued by Morgan Stanley, Barclays, Credit Suisse, Goldman Sachs and UBS. There are approximately 56 ETNs currently trading, including the iPath ETNs such as Crude Oil, Dow Jones Commodity Index, EUR/USD Exchange Rate.

More exotic underlying products for ETNs are being added all the time. These exotic tools presently include the VIX Mid-Term Futures and Global Carbon.

Let's start by taking a closer look at the actual built of an ETN as compared to an ETF

ETNs are a structured products created as a senior debt note by the issuing banks. In simple language, this means that the ETN is dependent on the credit of the underlying bank. Therein lays the first design difference. ETFs represent a stake in the actual underlying product and are not subject to the same credit risk. For the investor, there is more risk in ETNs due to the above and actual market risk. ETFs, on the other hand, are subject only to market risk. Although, ETNs are issued by major, top rated banks, if their credit rating is cut, it will negatively affect the ETN regardless of the underlying market move.

In the current environment of surprising negative bank news occurring almost daily, this is becoming a critical factor in choosing to invest in ETNs. On a more positive note, ETN track the underlying product/indexes exactly unlike ETFs. The reasoning behind this is a bit odd, but makes sense if you think about it. ETNs are guaranteed to track the underlying product tic for tic by the issuing bank. They replicate the performance exactly; wherein ETFs often have limits imposed making an exact replica impossible.

Of course, the exact tracking is minus the management fee imposed by the ETN. The management fee is the only payment or distribution in the ETN, which brings us to the next difference -- Taxes. ETFs are subject to make yearly capital gain and income distributions which are taxable events for the holder. ETNs do not make these distributions so the investor can defer taxation until the ETN is sold or matures.

In a sense, the ETN is more like a bond, and ETFs are more like stocks. If you are confident in the long term viability of the issuing bank, ETNs offer advantages not found in ETFs.

David Goodboy is Vice President of Business Development for a New York City based multi-strategy fund.