ETNs vs ETFs

ETNs, Exchange Trade Notes, and ETFs, Exchange Traded Funds, are very similar instruments, yet they have a significant difference.

Similarities:

- Both follow an index or a basket of stocks traded in an exchange, so can be traded freely on an intra-day basis (unlike mutual funds which investors can only trade at the end of the day).

- Both have very low fees

Differences:

- ETFs are structured like a mutual fund, you own a piece of the fund, and the corresponding number of shares in the companies or contracts it invests in (in the case of commodities)

- ETNs, on the other hand, are structured as debt, baked by a bank, so there is credit risk. If the bank goes under, so does that ETN. An example are the three ETNs issued by Lehman Brothers in February 2008: Opta S&P Listed Private Equity Index Net Return ETN , Opta Lehman Brothers Commodity Index Pure Beta Total Return ETN and Opta LBCI Pure Beta Agriculture Total Return ETN. You know what happened to Lehman Brothers. As they are treated as debt, in December 2007, the U.S. IRS issued an adverse tax ruling on currency linked ETNs. The rule stated that any financial instrument linked to a single currency regardless of whether the instrument is privately offered, publicly offered or traded on an exchange should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells any such financial instrument, including an ETN, or the contract, matures.

- In theory, ETFs have market risk, while ETNs have market and issuer risk.

Risk.

The Nasdaq states that "Exchange Traded Notes have hidden risks not found in standard Exchange Traded Funds, but they have greater flexibility than ETFs and give investors efficient access to niche markets poorly suited to ETFs. Understanding this risk/reward ratio is the key to ETN investing.ETNs are unsecured debt from their issuer, not direct ownership of stocks, bonds or other assets like ETFs. So if the provider goes bankrupt, investors end up holding the bag. This was the case with Lehman Brothers, whose three ETNs shuttered upon its demise".

Liquidity:

In terms of liquidity, ETFs are 10x larger

- ETNs: $5.6B in assets
- ETFs: $60B in assets

Largest ETFs:

1. SPDRs SPY, 70.73B
2. SPDR Gold Shares GLD, 35.05B
3. iShares MSCI EAFE Index EFA, 34.37B
4. iShares MSCI Emerging Markets Index EEM, 33.74B
5. iShares S&P 500 Index IVV, 20.44B
6. PowerShares QQQ QQQQ, 17.09B
7. iShares Barclays TIPS Bond TIP, 16.31B
8. Vanguard Emerging Markets Stock ETF VWO, 14.10B
9. iShares iBoxx $ Invest Grade Corp Bond LQD, 13.33B
10. iShares Russell 2000 Index IWM, 13.14B
11. Vanguard Total Stock Market ETF VTI, 12.35B
12. iShares Barclays Aggregate Bond AGG, 10.62B
13. iShares Russell 1000 Growth Index IWF, 10.42B
14. iShares MSCI Brazil Index EWZ, 10.17B

Largest ETNs:

1. Barclays iPath Dow Jones AIG Commodity Index (DJP)
2. Powershares DB Crude Oil Double Long (DXO)
3. Barclays iPath S&P GSCI Crude Oil (OIL)


Summary

In other words, ETNs act as bonds that don’t pay interest at a fixed rate, but pay a return on a given index. ETNs are typically registered under the Securities Act of 1933.

ETFs are regulated by the Investment Company Act of 1940, ensuring some protection of the assets of the ETF in the case the issuer goes bankrupt. This is not the case with ETNs, which are debt instruments only as good as the credit of the issuer. In other words, if the issuer goes under, your money is lost.


When you buy an ETN, such as OIL from Barclays, you get a promise that it will perform as stated (i.e., the performance of the Goldman Sachs Crude Oil Return Index). When you buy the USO ETF, you actually own some futures contracts on barrels of oil. If the fund manager goes under, shares should contunue to trade or your money will be exchanged for the shares, at least in theory.