Exchange Traded Notes: an Alternative To ETFs

Exchange-traded notes (ETN), are close cousins to exchange-traded funds (ETFs), but there are some key structural differences.

For investors interested in exploring this kind of investment, we'll explain how they work when it comes to index investing, and compare them to ETFs. 

ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. ETNs are more like bonds in that they are unsecured. ETFs provide investments into a fund that holds the assets it tracks, like stocks, bonds or gold.

Barclays Bank PLC, a 300-year-old financial institution with hundreds of millions in assets and a good credit rating from Standard & Poor's, provides its ETNs with a fairly dependable backing. But even with this kind of credibility, the investments are not free of credit risk. Despite its reputation, Barclays will never be as safe as a central bank, as we witnessed with the downfall of major banks, such as Lehman Brothers and Bear Stearns, during the last financial crisis. Even more stringent regulations requiring more safety capital don’t make banks completely immune from a collapse.

ETNs track their underlying indexes minus an annual expense of 75 basis points per year. Unlike ETFs, there are no tracking errors with ETNs.

Investors should treat ETNs as prepaid contracts. This means that any difference between the sale and purchase will be classified as capital gains. In comparison, the return from commodity-based ETFs will come from the interest on Treasury bills, short-term capital gains realized on the rolling of futures contracts, and long-term capital gains.

Since long-term capital gains are treated more favorably than short-term capital gains and interest, the tax treatment of ETNs should be more favorable than that of ETFs.

However, the owner of an ETN will owe income taxes on interest or coupon payments made by the ETN. For international investors, the differences are compounded as a treatment for these capital gains and will be treated differently in their home countries.

Outside of the tax treatment, the difference between ETNs and ETFs comes down to credit risk versus tracking risk.

ETNs possess credit risk, so if Barclays would go bankrupt, investors may have to get in line behind bigger creditors, and not receive the return they were promised. An ETF, on the other hand, has virtually no credit risk. But there is tracking risk involved with holding an ETF. In other words, there is a possibility that the ETF's returns will differ from its underlying index.

Now that you have a better understanding of the differences between ETNs and ETFs, which one should you choose? To some degree that will be determined by your tax bracket and your investment time horizon.

While the biggest benefit of an ETN is that the entire gain is treated as a capital gain, this gain is also deferred until the security is either sold or matures. That is something that should not be taken lightly by tax-conscious, long-term investors. With an ETF, capital gains and losses are realized as each futures contract is rolled into another one.

The big difference between ETNs and ETFs is between credit risk and tax treatment.

While the benefit of active management is arguably, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The creation of the ETN is a development all investors should learn about and consider adding to their portfolios.