Mutual funds have been around since the 1920s, although their popularity really began to soar starting in the 1960s.  By now most everyone I meet has a basic familiarity with these extremely useful investment vehicles.  Then came the Exchange Traded Fund (ETF), a variation of a mutual fund pioneered in the U.S. by the S&P Depository Receipt (or SPDR) in 1993. Although less understood and less utilized than mutual funds, ETF investment growth today is starting to eclipse that of traditional mutual funds.  But the financial services industry continues to push the envelope to create newer and more exotic investment opportunities.  In 2006 Barclays re-marketed a biotechnology index structured product – originally developed and issued by Morgan Stanley – under the trade name [iPath] Exchange-Traded Notes, and the ETN was born.  Since the two acronyms are so similar, many investors naturally assume that they are similar investment products.  Unfortunately, their differences are bigger than their similarities, and it’s important to understand them before making an investment decision.

First, a quick primer on ETFs.  Like traditional mutual funds, an ETF 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 you buy them from other investors, just as with stocks. That has two implications:

1. You can buy ETF shares anytime during the trading day, unlike mutual fund shares, which can only be purchased after the market has closed and the fund’s net asset value (NAV) can be calculated.
2. During periods of high demand, the prices of ETFs can exceed the NAV of their underlying assets, and vice-versa when the shares are unpopular. Since 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 NAV of the ETF’s shares.  Nonetheless, the difference can be significant at times.

An ETN, on the other hand, is a structured note, 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.  But an ETN is not really an investment in a bond, but instead in the valuation of the index.  When the index goes up, the price of the ETN increases concomitantly, and vice-versa.  Some ETNs additionally distribute interest periodically.

Why would an investor choose to invest in an ETN rather than in an ETF?  There are several reasons:

• ETNs can precisely track their index. This is 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.
• All those trades that ETFs are forced to make (in order to minimize index tracking error) generate capital gains that are taxed to the investor. So ETNs are more tax-efficient than ETFs, at least when it comes to capital gains.
• Some types of investments (such as commodities or master limited partnerships) generate Schedule K-1 forms during tax time that can make your annual tax reporting complex and cumbersome. Investing in an ETN that alternatively tracks an index of these various investments avoids the tax reporting issues since the ETN is simply a debt investment.

Probably the biggest reason to choose an ETN over an ETF is because there are very few investment opportunities offering both.  ETFs for the most part are focused on tracking stock and bond indices, while ETNs (perhaps because of their greater tax reporting simplicity) tend to address non-traditional alternative investments such as commodities and currencies.

Since an ETN is a debt investment, its biggest downside is the credit risk of the financial institution.  If the issuer were to go bankrupt, you could lose your entire investment.  This risk is generally considered low since most ETNs are issued by huge multi-national banks such as UBS or Barclay’s.  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.  But be aware of the differences between the two.  The similarity in their names belies the significant difference in their structure and function.