There are thousands of ETFs, or exchange-traded funds, in the modern investing environment. But what is an ETN, and how is this product similar or different from an ETF?
An ETF is a type of investment fund that makes sense when you unpack the first three words of the acronym. It's "exchange traded," meaning it gets prices printed across the trading day like your favorite blue chip stocks. But it's also a "fund," meaning it is a pool of other financial assets like traditional mutual funds.
It's that last word, "funds," that makes the difference with ETN investing. ETNs are exchange-traded "notes," which means they are most commonly tracking an index or data point – not an asset that you directly own via the fund.
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It's a subtle but important difference, and here's what it means.
What is the difference between an ETN and an ETF?
For starters, let's briefly run through what ETNs and ETFs have in common:
- They are both bought and sold like stock through your favorite broker – just type in the ticker and execute a trade.
- ETNs and ETFs are both exchange traded, with prices printed across the trading day.
- Both ETNs and ETFs have the potential to be narrow, but generally both are ways to play broad trends in the market.
- They both come with investment risk, and require you to think carefully about your goals and the current investing environment before making a trade.
With that out of the way, let's now explore the places where these investment products differ.
- The biggest difference is that ETFs directly own assets, and investors get direct stakes in how those assets behave. For instance, if you own one of the many popular exchange-traded funds like the SPDR S&P 500 ETF Trust (SPY), you have a stake in all 500 stocks in the S&P 500 Index. As their share prices go up, your ETF investment appreciates. And, as they pay dividends, that cash is passed on to you.
- ETNs do not directly own assets. They are instead "unsecured" notes that are simply designed to track an investment or group of investments. In other words, you buy into the index – not the constituent parts of that index.
- The downsides of that include you won't get dividends. But one of the upsides is that you don't have to worry about short-term tax implications, because you're just tracking the index and not directly exposed to the buying and selling that's happening behind the scenes.
What are the largest ETNs?
To make all this practical, let's look at some of the most popular ETNs on Wall Street and explore how they behave and why some investors find them appealing.
The largest ETN out there is the JPMorgan Alerian MLP ETN (AMJ) with almost $3 billion in assets. Master limited partnerships, or MLPs, are a unique asset class on Wall Street that are structured as partnerships instead of common stock. As such, they come with some unique factors including tax treatment. Without bogging down commentary here on the specifics of MLPs, this instrument from JPMorgan is designed to simplify some of those factors.
Another very popular ETN at this moment is the MicroSectors FANG Index 3X Leveraged ETN (FNGU), a super-charged instrument that aims to deliver three times the daily returns of an index linked to 10 popular stocks including Meta Platforms (META) and Tesla (TSLA), among others. In order to get that 3X approach, this ETN uses complex financial instruments. Investors in this ETN don't own any of this directly, just exposure to the underlying index.
There are many other ETNs out there, but these approaches represent some of the use cases for investors looking beyond traditional ETFs.
What are the risks of ETN investing?
One final word of warning: The unsecured nature of ETNs carries a number of risks that don't exist in more traditional mutual funds or their ETF cousins.
For starters, if you're taking on an aggressive strategy like trying to get three times the return of high-flying tech stocks … well, don't be surprised if you're stuck with three times the losses if things go the wrong way. "Leveraged" products and other complex ETNs can be risky and often require a higher level of investor knowledge as well as higher risk tolerance.
Also, remember you're tracking an index instead of having a hard link to an asset. That comes with challenges that commonly are referred to as "correlation risk." For instance, those aforementioned 3X funds don't always move exactly three times the direction of the underlying assets they're attempting to track because of costs and other frictions in the trading process. Sometimes your profits may be less or your losses deeper because of this variance. After all, you don't own a direct stake with an ETN. As such, you should never expect a 1-to-1 link just because a certain word is in the name of the product.
There are certainly cases where ETNs do fit with a comprehensive investment strategy, however. Just as it can be risky to put all your eggs in a single stock, it is naturally risky to put everything in one single ETN. But used responsibly as part of a diversified portfolio, ETNs can be a useful part of your comprehensive investing strategy.
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