Exchange traded notes

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

When an investor purchases shares of an ETF, they gain ownership of securities in the fund. When securities held in the fund increase in value, the ETF increases (and vice versa). The securities in the ETF’s portfolio are structured to match the index it tracks. For example, the Spyder ETF contains the 500 stocks part of the S&P 500. Simply put, ETF owners make money when their investments rise in value.

When an investor purchases an ETN, they loan money to a financial institution. Officially structured as a debt security, an ETN represents the promise from an issuer to pay its investors the return of an index. Unlike ETFs, ETNs maintain a maturity date. This is the day the issuer must pay the index’s return to the ETN holders.

Because ETNs are considered debt instruments, they are subject to default (credit) risk. If the issuer goes bankrupt, its investors could lose their entire investment (for reference, here’s the story on Lehman Brothers ETNs. Conversely, ETFs are not subject to default risk as they represent ownership of the underlying securities in the ETF (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 sold short. Additionally, both securities are tax efficient, although ETNs typically subject their investors to less taxation than ETFs.* Because there is no ownership of portfolio assets involved with an ETN, there are no dividend or capital gains payments. Therefore, ETNs are only taxable 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.