Exchange traded notes

Exchange traded notes (ETNs) are technically debt securities, but the exam may compare and contrast them with exchange traded funds (ETFs). Both can provide returns based on the performance of an underlying index, but they do it in different ways.

When you purchase shares of an ETF, you gain an ownership interest in the securities held by the fund. If the securities in the fund increase in value, the ETF’s share price generally increases (and vice versa). The ETF’s portfolio is structured to match the index it tracks. For example, the Spyder ETF holds the 500 stocks that make up the S&P 500. In other words, ETF investors generally profit when the underlying holdings rise in value.

When you purchase an ETN, you’re lending money to a financial institution. Because an ETN is structured as a debt security, it represents the issuer’s promise to pay investors the return of an index. Unlike ETFs, ETNs have a maturity date. On that date, the issuer must pay the index’s return to ETN holders.

Because ETNs are debt instruments, they are subject to default (credit) risk. If the issuer goes bankrupt, investors could lose their entire investment (for reference, here’s the story on Lehman Brothers ETNs). By contrast, ETFs are not subject to default risk in the same way because they represent ownership of the underlying securities held by the fund (not a promise to repay borrowed funds).

Like ETFs, ETNs are negotiable securities that trade in the secondary market, can be bought on margin (with borrowed money), and can be sold short. Additionally, both securities are tax efficient, although ETNs typically subject their investors to less taxation than ETFs.* Because an ETN doesn’t involve ownership of portfolio assets, there are generally no dividend or capital gains payments. As a result, ETNs are typically taxable only when sold or at maturity.

*Most ETFs are passively managed. Therefore, an ETF’s portfolio involves less trading, resulting in fewer taxable transactions reported to the IRS. This is why ETFs are considered tax efficient.