Exchange Traded Funds (aka ETFs) and Exchange Traded Notes (ETNs) appear to be very similar when viewed as prospective investment vehicles by the individual investor. Some important differences may never come into play, but should be understood before investing your capital.
First, let’s review the similarities. Both ETFs and ETNs are easily bought or sold on any day the financial markets are open for business. In other words, they offer a high level of liquidity if you need your money for some other purpose.
The second characteristic in common is that most ETFs and ETNs performance as an investment vehicle is intended to mimic a well defined index. An investment index is a compilation of stocks, bonds or other category of investment developed by a formula or a committee and one of the companies that specializes in building indexes. Dow Jones, Standard & Poor’s and the Financial Times are three of the more recognizable names in the index business, but there are many smaller players.
Indexes almost everyone has heard of include the Dow Jones Industrial Average and the S&P 500 Index. There are indexes for just about any category of investment you can think of though, including currencies, commodities, individual foreign countries and specific industries.
In a perfect world, where everything goes according to plan, ETFs and ETNs could be totally interchangeable. However, we know there is no such thing as perfection in investing, so investors should have a basic understanding of the vehicles in which they invest. Let’s review some of the differences that may impact your choice.
ETF’s are pretty close to the concept of a traditional mutual fund, with the exception of the purchase and sale taking place on an exchange instead of purchasing or redeeming from the sponsoring mutual fund company. The ETF shares you buy provide pro-rata ownership of the underlying securities held by the fund, which are intended to mimic the designated index as closely as possible.
Buying and selling securities in real life is not the same as listing them on paper as components in an index. Spreads between the bid and offer price for stocks and bonds and transaction fees can all combine to create a bit of a drag on the funds ability to exactly mimic the performance of the index. In some cases, for liquidity reasons, the ETF may not own all of the securities in the index, but rather a representative sample to accomplish the goal. This creates the potential for performance differences.
In general ETFs are regarded as highly tax efficient with a goal of having zero capital gains distributions as long as the shares are held continuously. Dividends and interest received from the underlying investments flows through to you as the shareholder.
ETNs are a bit more complex. As a note, ETNs are a debt obligation of the issuing company. Like their ETF cousins, they are designed to deliver the performance of a designated index, but are even better at doing so than the ETF. Why? The ETN doesn’t actually hold any investments. When you buy an ETN, you are making a loan to the issuing company, and it can do whatever it wants with your capital. Its contractual obligation is to pay you the principal plus (or minus) the return achieved by the designated index from the time you purchase through the date of maturity of the note.
If the issuing company were to experience bankruptcy, the debt obligation tied to ETNs could, in theory, be thrown out by a court and investors could be out of luck. So why buy an ETN rather than an ETF? ETNs have the ability to return exactly what the designated index returns because they don’t have the potential performance inhibitors described above for ETFs. Also, ETNs may be even more tax efficient than ETFs because they do not have to distribute interest or dividend payments each year like traditional mutual funds and ETFs. This is because they don’t’ actually hold the investments like an ETF does.
For most investors the issue of ETF vs. ETN comes down to the superior index tracking capability of the ETN vs. the possible default of the ETN’s issuing company. This risk can be minimized by purchasing ETNs issued by firms that are large and credit worthy. As I wrote earlier, in normal times these issues are not generally too important, but times aren’t always normal.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. www.breitercapital.com
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.