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An investor's guide to ETFs and ETNs: A comparative study

Part 2
An investor's guide to ETFs and ETNs: A comparative study (Part 2 of 6)

Comparing ETNs with ETFs: The must-know pros of ETNs

Although the number of investors in ETFs far exceeds the number of those parking their money in ETNs, there are certain advantages that ETNs enjoy over ETFs. The benefits of investing in ETNs versus ETFs are:

Tracking errors

Even when ETFs aim to replicate the returns achieved by the respective indices they track, in practice, they achieve varying levels of success, and more often, under-perform. This is largely because of the expenses associated with the buying and selling of the underlying assets, which cause some amount of divergence in returns from the index they track. This makes the fund under-perform the index over time, also known as tracking error.

Tracking error in the VNQ ETF tracking the RMZ IndexEnlarge Graph

For example, in the chart above, the Vanguard REIT Index ETF (VNQ), which tracks the MSCI US REIT Index (RMZ) shows continuous divergence in returns from its underlying index over the 15-day period taken into consideration.

Similarly, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) with holdings in Sprint Corporation (S), and First Data Corp (FDC), or the SPDR Health Care Select Sector Fund (XLV), with holdings in Johnson & Johnson (JNJ) and Pfizer Inc (PFE), may decide to change (increase or decrease) their holdings in any of these companies to match the returns of their underlying index.

This does not happen with ETNs. There’s no tracking error because the fund itself isn’t actively tracking. An ETN does not rely on the buying and selling of the underlying asset. So, expenses are not amassed. Market forces will cause the fund to track the underlying asset, but it’s not the fund doing the tracking. An investor who owns a note is promised a contracted rate of return by the issuer. An ETN simply pays investors once the fund matures based on the price of the asset or index.

Tax efficiency

Since ETNs don’t actually hold any securities, they avoid the issue of having to buy and sell securities in order to rebalance the underlying basket, which can result in a taxable capital gain situation if a similar event happens for a holder of an ETF. So, the lack of trade makes ETNs more tax efficient than their ETF counterparts. ETFs are subject to making yearly capital gains and income distributions, which are taxable events for the holder. ETNs do not make these distributions so the investor can defer taxation until the ETN matures or is sold.

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