Exchange traded notes

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

When you buy shares of an ETF, you gain an ownership interest in the securities held by the fund. If the securities in the fund rise in value, the ETF’s share price generally rises (and vice versa). The ETF’s portfolio is built to track its index. For example, the SPDR ETF holds the 500 stocks in the S&P 500. In simple terms, ETF investors benefit when the underlying holdings increase in value.

When you buy an ETN, you’re lending money to a financial institution. An ETN is structured as a debt security: it’s the issuer’s promise to pay investors a return linked to an index. Unlike ETFs, ETNs have a maturity date. On that date, the issuer is obligated to pay the index-linked return to ETN holders.

Because ETNs are debt instruments, they’re 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 aren’t subject to issuer default risk in the same way, because an ETF represents ownership of the underlying securities held in the fund (not a promise to repay borrowed funds).

Like ETFs, ETNs are negotiable securities that trade in the secondary market. They can be bought on margin (with borrowed money) and sold short.

Additionally, both securities are considered tax efficient, although ETNs typically subject investors to less taxation than ETFs.* Since ETNs don’t involve ownership of portfolio assets, there are generally no dividend or capital gains distributions. 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.