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An ETN is typically issued by financial institutions and bases its return on a market index. They have much in common with bonds and at maturity, it will pay the return of the index it tracks. However, ETNs do not pay any interest payments like a bond, and their prices fluctuate like the prices of stocks.

When an ETN matures, the financial institution takes out fees, then pays the investor cash based on the performance of the underlying index. Since ETNs trade on major exchanges like stocks, investors can buy and sell them and make money from the difference between the purchase and sale prices, minus any fees. ETNs are a subcategory within the group of Exchange Traded Products ETPs.

ETFs own the securities in the index they track. For example, an ETF that tracks the S&P 500 Index owns all 500 stocks in the S&P. ETNs do not provide investors ownership of the securities, but are merely paid the return that the index produces. As a result, ETNs are similar to debt securities.

Another important characteristic of ETFs (and mutual funds) is that they're legally separate from the company that manages them. They are structured as separate "investment companies," "limited partnerships" or "trusts." This matters because even if the parent company behind the ETF goes bankrupt, the assets of the ETF itself are completely separate and investors will still own the assets held by the ETF. ETNs are different. Instead of being an independent pool of securities, an ETN is a bond issued by a large bank or other financial institution. That company promises to pay ETN holders the return on an index over a certain period of time and return the principal of the investment at maturity. However, if something happens to that company and it i's unable to make good on its promise to pay, ETN holders could suffer a complete loss or be left with an amount that is worth much less than initially invested.

Another important difference is that ETNs (unlike ETFs) are not overseen by a board of directors who are tasked with looking out for investors. Instead, decisions about the management of an ETN are determined solely by the issuer based on the rules they've laid out in the ETN's prospectus and pricing supplements. In some cases, the issuers of ETNs may engage in proprietary trading activities in their own accounts that are contrary to the interests of investors.

Taxes^*

Because ETNs don't hold any portfolio securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN. The value of the dividends is incorporated into the index's return but is not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs which regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. When the investor sells the ETN, the investor is subject to a long-term capital gains tax. The taxable event occurs only when the investor sells the ETN. With conventional ETFs, a long-term holder would be subject to capital gains tax each year. The ability to significantly boost returns by escaping annual taxes on dividends is a huge benefit to ETNs.

^*Tax benefits may vary depending on the domicile of the investor.

Tracking error reduced

Theoretically, an ETF should give investors the exact return of the index it tracks, minus the expense ratio. But sometimes the difference between the ETF and its index is larger than the expense ratio. This extra difference between the portfolio's return and the value of the index is called the tracking error. Tracking error can be a significant issue for ETFs that are unable to hold all the components of a benchmark index, either because there are too many components and/or the components are illiquid. As a result, the value of the ETF and the value of the benchmark index may diverge. In contrast, the ETN issuer promises to pay the full value of the index, no matter what, minus the expense ratio.

Market access

ETNs bring the financial engineering technology of investment banks to the retail investor. They provide access to markets and complex strategies that conventional retail investment products cannot achieve. For example, Barclays Bank in 2011 issued ETNs that allowed investors to profit from increases in stock market volatility.

Credit risk

ETNs rely on the credit worthiness of their issuers, just like unsecured bonds. If the issuer defaults, an ETN's investors may receive only pennies on the dollar or nothing at all, and investors should remember that credit risk can change quickly.

Liquidity risk

The trading activity of ETNs varies widely. For ETNs with very low trading activity, bid-ask spreads can be exceptionally wide.

Issuance risk

Unlike ETFs where the supply of shares outstanding fluctuates in response to investor demand, ETNs are created only by their issuers who are effectively issuing new debt each time they create additional units. At times, issuers may be unable to create new notes without violating the capital requirements set by bank regulators. Investors who purchase ETNs at a premium (pay a higher price than the value of the note based on the performance of the underlying index or referenced asset), are at risk of losing money when issuance resumes and the premium dissipates, or if the note is called by the issuer who returns only the indicative value.

Closure risk

There are multiple ways for an issuer to effectively close an ETN. An issuer may call the note by returning the value of the note less fees (also known as accelerated redemption). However, not all ETNs have terms in their prospectuses or pricing supplements which allow for this. A much less friendly alternative is for issuers to delist the note from national exchanges and suspend new issuance. When this happens, ETN investors are left with a pretty unpleasant choice. They can either hold the note until it matures, which could be up to 40 years away, or trade the ETN in the over-the-counter (OTC) market where spreads can be even wider than on national exchanges.