• The following explains the characteristics of ETNs and ETFs and the key differences between them.
• This information is intended for asset managers looking to implement comprehensive strategies with exchange-traded products.
• FlexFunds offers an asset securitization program to improve the liquidity of ETFs and ETNs. For more information, please do not hesitate to contact our experts.

Within the broad range of exchange-traded products (ETPs), ETNs and ETFs stand out. These financial vehicles are often regarded as equivalent, but they carry key differences between them.

What is an ETN?

Definition and technical characteristics

An exchange-traded note (ETN) is a financial instrument issued as debt by a financial institution, designed to replicate the performance of an underlying asset.

Unlike a fund or an ETF, an ETN does not confer ownership of the index assets; instead, it functions as a promissory note traded with a future maturity date.

How an ETN is structured

An ETN’s structure combines debt and derivative elements. The issuer internally invests in medium- to long-term debt instruments and may use financial swaps to replicate the underlying index.

It is common for the issuing bank to enter into a return swap agreement with another counterparty (another broker or financial institution): the counterparty agrees to pay the index return, and in exchange the issuer pays a fixed fee.

In this way, the ETN contractually establishes that the investment manager will be repaid the initial capital plus the index return at maturity.

What is an ETF?

General concept and mechanics

An exchange-traded fund (ETF) is an investment fund that trades continuously on an exchange, combining the diversification of an asset portfolio with the trading flexibility of a stock.

Unlike a mutual fund, whose shares are bought or sold at the daily net asset value, an ETF can be traded throughout the trading session.

At the close of the session, a net asset value (NAV) is calculated based on the fund’s assets, and the market mechanism (creation and redemption of shares) tends to keep the ETF’s price close to that NAV.

Underlying assets and replication

ETFs can hold a wide range of assets: from broad baskets of stocks or bonds to commodities, currencies, or specialized strategies (inverse, leveraged, volatility, etc.).

The replication method defines the fund’s internal structure. As mentioned, physical replication means the fund acquires the actual securities in the index, offering transparency (it is clear exactly what the fund holds) and minimizing tracking error, except for expenses and minor market differences.

A synthetic replication ETF, by contrast, minimizes tracking error by using a swap. Specifically, the fund enters into a contract with a bank that transfers the index return with high precision, though subject to counterparty risk.

ETN vs. ETF: Key differences every manager should know

Credit risk vs. asset ownership

At the structural and risk level, there are two fundamental differences between ETNs and ETFs.

With an ETN, the investment manager depends entirely on the issuer’s ability to pay. If the issuing bank were to fail, the investment would be lost, even if the index had performed well.

An ETF, by contrast, represents a segregated asset pool (often with senior debt status within the fund) backed by physical securities, meaning its risk is limited to the market risk of the index rather than that of a single issuer.

Tax and liquidity implications

Tax implications and liquidity also differ between the two.

From a tax standpoint, ETNs typically do not generate dividend or interest flows, so the only taxable income arises when the note is sold or reaches maturity. As a general rule, the gain is classified as capital appreciation (capital gains).

ETFs, for their part, may distribute dividends or periodic income (depending on the strategy). When they do, such distributions are generally subject to taxation in the fiscal year in which they are received by the position holder.

As for liquidity, ETFs incorporate a continuous creation/redemption mechanism through authorized participants. This keeps the market price tightly aligned with the value of the underlying assets and provides additional liquidity even when trading volume is low.

In contrast, ETNs depend on the supply managed by their issuer: if the issuer stops creating new notes, the existing ones may trade at a premium due to limited supply.

Which one is right for your investment strategy?

Considerations based on risk profile and objectives

The choice between ETFs and ETNs depends on the level of risk the investment manager is willing to take on and the strategy being pursued.

In general, ETFs are better suited to conservative or institutional profiles that value the security of diversification and portfolio transparency: by investing in an ETF, the manager knows that the fund’s actual portfolio backs the investment, minimizing credit risk.

ETNs, on the other hand, are more complex and higher-risk investment instruments, recommended for risk-tolerant profiles seeking very specific exposures.

Since an ETN is unsecured, it is advisable to evaluate the issuer’s credit rating and plan for the maturity date. In addition, the path taken by the index may have less impact on certain specialized ETNs, such as leveraged or inverse ones that avoid the “path dependence” of their ETF equivalents, as they settle directly at maturity.

Access to non-conventional exposures through ETNs

One of the distinctive advantages of ETNs is their ability to provide exposure to markets or assets that are difficult to access and cannot always be easily replicated with a traditional ETF.

Thanks to their debt and swap structure, ETNs facilitate investment in specialized indices or niche themes (complex commodities, emerging currencies, volatility, the energy sector, cryptocurrencies, etc.) without directly holding those assets.

In fact, this type of note was originally designed to broaden institutional access to sophisticated strategies that had until then been limited to large funds or investment banks.

For example, there are ETNs based on cryptocurrency baskets or volatility indices that offer diversified exposure to these emerging markets. However, that added flexibility comes with credit risk.

It is worth noting that both ETFs and ETNs can be securitized to improve distribution, through companies such as FlexFunds.

To find out more about FlexFunds products, do not hesitate to contact our executives. We will be glad to assist you!

Sources:

• https://www.investopedia.com/financial-edge/0213/etf-or-etn-whats-the-difference.aspx
• https://hexn.io/blog/what-are-exchange-traded-notes-etns-igz026mbaneqc0mmncd352tp
• https://www.degiro.com/uk/knowledge/investing-in-etfs/etns-etcs
• https://www.fondoscotizados.com/%C2%BFque-es-un-etn/
• https://www.xtb.com/lat/formacion/fondos-mutuos-vs-etfs-diferencias-costos