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Most investors are knowledgeable about exchange-traded funds (ETFs) but they know very little of exchange-traded notes (ETNs). Possibly the biggest mistake that investors make in this regard is when they buy and hold ETNs, assuming they are just another type of ETF.
ETNs can be great investing tools but it’s important to understand the risks and rewards of these investment securities. And because they are often confused with ETFs, we’ll draw some basic comparisons that will provide more clarity about the differences and best uses of ETFs and ETNs.
On the surface, exchange-traded notes have many similarities to exchange-traded funds. Like ETFs, ETNs can be bought and sold on a stock exchange throughout the trading day, they usually track the performance of a benchmark index, and they can provide access to focused areas of the market, such industrial sectors, various fixed-income niches, commodities and currencies.
How ETNs Differ From ETFs
However, there is one primary difference between the two security types: An ETN is actually a bond, which is why they are called “notes” and not “funds.” However ETNs don’t typically pay interest at a fixed rate like a bond does. Instead, investors get a return based upon the performance of the benchmark index.
For example, when you buy an ETN, you are actually buying a promise from the issuer, usually a banking entity, to pay you a return that is linked to the performance of the benchmark index. With ETFs, as with conventional mutual funds, investors own a stake in a portfolio of underlying assets.
So if you were to buy a popular ETN, such as JPMorgan Alerian MLP (NYSEArca: AMJ), you’re getting a promise from JPMorgan (NYSE: JPM) to pay a return, net of fees and expenses, that tracks the performance of a basket of energy master limited partnerships.
This brings up a good point to keep in mind: Since a guarantee is only as good as the guarantor, be sure to limit your ETN investing to large issuing companies that are less susceptible to failure, because if the firm has liquidity issues or even declares bankruptcy, the firm could default on the note (your ETN). For a quick reality check on the potential dangers of buying these notes, recall the big bank failures of 2007 and 2008. Do you remember Lehman Brothers? It had some outstanding ETNs at the time of its collapse.
Should You Invest in Exchange-Traded Notes?
After learning of the potential risks of ETNs, you might think they’re generally a bad idea. But this is not the case. As with all other investment security types, there are benefits if they are used correctly and investors need to understand the risks involved before buying.
ETNs can be an effective and useful means of buying into areas of the market that are otherwise hard to access. We already mentioned MLPs, but another niche area where ETNs can be good tools is with volatility trading, such as another big ETN, iPath S&P 500 VIX ST Futures (NYSEArca: VXX).
Tax efficiency is one of the greatest attributes of ETNs. Since ETNs are taxed like a stock, investors can use them to avoid the tax complexities of certain investments like MLPs and commodities.
The bottom line for investing in ETNs that investors need to understand the credit risk aspect of holding them and to keep in mind that they are not just some kind of new ETF.
And, as with any other kind of investment security, do your homework before buying and don’t allocate too large of a percentage of your portfolio to any one area of the market.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, S.C. He personally does not hold any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
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