These days, exchange-traded funds (ETFs) are popular assets as they offer lower fees and a simplistic price action similar to one of stocks.
In the finance sphere, they belong to one family with ETNs, – exchange-traded notes.
In this article, we are revealing what these two really are, as well as what similarities and differences they have. Check it all out below.
Defining Exchange-traded Funds (ETFs)
ETFs are very much like a mutual fund and an investment pool. It is made, first of all, to track indexes, commodities, and other assets and can be bought and sold just like any stocks.
In fact, it is able to track anything, starting with prices of particular commodities and finishing with whole investment plans and strategies.
ETFs are called ‘baskets of securities and are exchanged in a simple procedure on classical exchanges.
ETFs can be:
- Passive / active
- Sector / industry
So, when purchasing an ETF, you buy a tool designed to hold and track the asset. They help investors to manage risks, diversify portfolios, and go for a no-expense ratio investment.
What is Special About Exchange-traded Notes (ETNs)?
What is ETN and how to understand it? They act more like bonds and, in essence, are debt tools, not assets.
More precisely, they are unsecured debt notes (securities) created by institutions that can also be held for a long or sold when an owner wants. They are also capable of tracking underlying indexes on exchanges and stocks.
They act like bonds. However, they do not need any interest payment. As a result, ETN prices fluctuate, just like in stocks.
Now, there is a lot in common between exchange-traded funds and exchange-traded notes. This may be the main reason why the line dividing these two concepts often gets blurred. Here is the list of similarities:
- Both are created for the purpose of tracking underlying assets.
- Both offer a low expense ratio (i.e., how much of the asset is used for operating and governance expenses) compared to mutual funds.
- Both are traded on many exchange platforms together with stocks.
- Both provide investors with chances to invest in a number of different market areas.
This makes ETFs and ETNs very much alike if we look at the surface of their definitions. Next, let us consider what makes them inherently different things to invest in.
Despite having much in common, potential investors should know about the most significant things making them different.
The Structure of Ownership in ETFs and ETNs.
ETFs are assets, whereas ETNs are debt instruments. This difference has a huge impact on their price formation and performance.
For instance, purchasing an ETF makes you an actual owner, while buying an ETN, you just receive a tool to manage debt.
Banks or institutions issue the latter, and the ETN is never backed up by an asset kept in a custodian bank.
The fact that institutions are issuers makes the ETN investment reliant on its reputation and ability to avoid bankruptcy.
Meanwhile, ETFs are bonds, stocks, futures contracts, and even precious metals that are actually located in custodian banks.
Ways of Taxation.
Tax treatment is another point making these two different. With ETNs, it still remains a big secret.
In contrast, interest payments and IRS taxes dividends of ETFs are taxed similarly to income received from bonds and stocks.
So if there is profit from the ETFs and it is sold at a gain, they are also taxed like bonds and stocks.
Now, ETFs are fairly simple to make. Investors offer the issuer an underlying stock in return for shares of ETFs.
These assets are redeemed in a reverse process: a seller from an institution requests individual stocks in return for shares. Both processes are transparent and don’t have many restrictions.
Creating and redeeming ETNs is more complex. Normally, they are issued in a fixed amount at the start. However, additional shares can also be made if the issuing firm is willing.
Here’s an interesting detail: since the issuer is a firm and an ETN is a debt, there must be a limit to shares it can make.
In case the firm reaches the maximum amount of internal debt limit, no more shares can be issued.
The redemption of ETNs reminds the redemption of ETFs, where shares in blocks of 50,000 are received back by the issuer according to the indicative value.
To conclude, ETFs and ETNs are both similar and different, and when you know what you own (or are about to purchase) and how these funds work, the investment goal gets in place, and you make the right financial decisions.
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