Thanks to the proliferation of 401(k) and similar retirement plans, most everyone today has become familiar with mutual funds.
In 1993, the first exchange-traded fund (ETF) came into being. Although not as well understood as mutual funds, ETF investment growth today is starting to eclipse that of traditional mutual funds.
Then in 2006, Barclays remarketed a biotechnology index-structured product. It was originally developed and issued by Morgan Stanley under the trade name iPath Exchange-Traded Notes, and Barclays took those capital letters to create the ETN.
Because the two acronyms are similar, many investors naturally assume that they are similar investment products. They are not, in fact, and it’s important to understand their differences before making an investment decision.
Understanding the difference
An ETF works like a traditional mutual fund in some regards. It represents a basket of assets such as stocks or bonds. Unlike a mutual fund, investors cannot buy ETF shares directly from the investment company that offers them. Instead, they are purchased from other investors, just as with stocks.
That has two implications. First, you can buy ETF shares anytime during the trading day. This is different from mutual fund shares, which can only be purchased after the market has closed and the fund’s net asset value can be calculated. Second, during periods of high demand, the prices of ETFs can exceed the net asset value of their underlying assets – and vice versa when the shares are unpopular. Because buyers generally do not want to pay a lot more than an ETF is worth, there is an arbitrage mechanism that tends to minimize the potential deviation between the market price and the net asset value of the ETF’s shares. Nonetheless, the difference can be significant at times.
On the other hand, an ETN is a structured note, meaning it is a debt security issued by a financial institution (typically a bank) whose return is linked to the performance of a reference index. Structured notes have a fixed maturity and include two components, a bond and an embedded derivative. When the value of the index rises, the price of the ETN increases concomitantly, and vice versa.
Benefits of ETNs
Why would you choose to invest in an ETN rather than in an ETF? There are several reasons, primary among them that ETNs can precisely track their index. This is more difficult for ETFs because of the constant fluctuation of their holdings’ prices and the numerous trades they have to execute to maintain their proper proportions. The trades ETFs make to minimize index tracking errors generate capital gains that are taxed to the investor. So ETNs can be more tax-efficient than ETFs.
In addition, partnership investments (such as in real estate or in oil producers) generate Schedule K-1 forms that can make annual tax reporting complex and cumbersome. Investing in an ETN that alternatively tracks an index of such investments avoids the tax reporting issues because the ETN is simply a debt investment.
The biggest downside of an ETN is the credit risk of the issuing financial institution. If the issuer were to go bankrupt, you could lose your entire investment. This risk is generally considered low because most ETNs are issued by huge multinational banks such as UBS or Barclays. Nonetheless, we have experienced spectacular big-bank collapses in the past. Remember Lehman Brothers?
Both ETNs and ETFs have their places in a diversified investment portfolio. There is little overlap right now, with ETFs mostly focused on tracking stock and bond indices and ETNs addressing alternative investments such as commodities and currencies. But be aware of the differences between the two. The similarity in their names belies the significant difference in their structure and function.
Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, call 209-4062 or email artie.green@ cognizantwealth.com.