How ETNs Differ From ETFs

Exchange-traded funds have been in existence for over two decades now and millions of investors now use these flexible tools as their primary investment vehicle of choice.  ETFs are extolled for being diversified, transparent, liquid, low-cost, and tax-efficient.  Put simply, they allow you the ability to instantly access a basket of stocks, bonds, commodities, or currencies with the click of a button at any time during the trading day. 

ETF providers are constantly coming up with innovative index strategies that push the envelope in terms of sophistication or access to previously esoteric markets for everyday investors.  With that in mind, the traditional ETF model can be prohibitive when it comes time to access commodities futures or other complex markets.  This is often due to the tax, liquidity, and index tracking impact of these strategies. 

In order to combat these challenges, the exchange-traded note was created to allow investors the flexibility to access difficult-to-reach markets.  An ETN differs from an ETF in that it is a senior, unsecured debt instrument that is issued by a major bank such as Barclays.  They do not give you direct ownership in a basket of underlying securities, but rather are designed to track a specific index while minimizing tracking error.

The single biggest drawback in the structure of an ETN is that if the issuing bank were to go bankrupt, the shareholders of the ETN would be susceptible to a total default.  However, the majority of ETNs in existence today are issued by large banks with healthy balance sheets which make this a minimal risk. 

One of the benefits of owning an ETN is their tax efficiency.  ETFs that operate in the commodity space such as the United States Oil Fund (USO) are structured as a partnership that generates a K-1 for shareholders.  This can be a major tax headache that could be avoided by purchasing the iPath S&P GSCI Crude Oil Total Return ETN (OIL), which gives you an almost identical return without the added tax burden.

Investors that do decide to invest in an ETN should be sure to thoroughly research the underlying index, fees, credit health of the issuer, and maturity date of the fund.  Although ETNs tend to run towards more sophisticated strategies, they can be suitable for many different types of investors.  The key is to comprehensively understand the products before you take the plunge.