Decmeber 21, 2011 by tfroberts

Exchange Traded Funds (ETFs) are being used in place of individual stocks or mutual funds by individual and institutional investors. One advantage of using most ETFs is that the basket of investments, the index, is defined and transparent. If the investment index that the ETF developer wants to track is not easily made up of tradable securities, such as company stock, they can use other financial vehicles. One common vehicle is an Exchange Traded Note (ETN). However, there are some differences you should be aware of before investing in an ETN.

An ETN may be used for asset classes such as commodities or to utilize derivatives, leverage and alternative strategies. You may have seen funds advertised as multiples of an index such as "2X S&P 500" or volatility (VIX). These are often offered as an ETN. Structured products have been packaged as ETNs.

Unlike ETFs, an ETN is a note issued by a bank or other financial institution. The note has a maturity date when you realize the gain or loss. Like any other note or loan, payment is dependent upon the strength of the borrower or institution. This is an additional risk to be considered. Four of the five largest issuers of ETNs are European banks such as Barclays and UBS.

Some ETNs allow access to investments at lower investment thresholds and increased liquidity. That means smaller investors can invest. Not all ETNs are liquid. Some may not be easily sold at a reasonable price.

The returns are currently treated as capital gains that can have favorable tax treatment. The IRS has not finalized the ruling on this yet so this is subject to change.

As with any investment, due diligence is required to assure your investment matches your needs, risk ability and time horizons.