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Basic trading education – ETFs vs. ETNs

TradingPub Admin | May 3, 2013

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If you want to learn more about how you can use exchange-traded funds (ETFs) and exchange-traded notes (ETNs) to fulfill your investment objectives, there is free trading education available in this article.

ETF basics
Right about now, you might be wondering what an ETF is, and why they are relevant to you and your investing plans. An ETF is a stock certificate that provides the purchaser with exposure to an underlying bundle of assets or some sort of management strategy.

Widespread investing options
These funds can be used to invest in the S&P 500 Index, other noteworthy groups of stocks, commodities and also strategies such as those involving mergers and acquisitions. There are also leveraged and inverse ETFs, with the first type harnessing debt to amplify returns, and the second utilizing derivatives contracts in an effort to provide price movements that are the exact opposite of those for the underlying basket of assets.

Physical and synthetic ETFs
The difference between physical and synthetic versions of these funds is important for you to know if you want to trade these securities. If you invest in a physical ETF, the security purchases the underlying assets. An example of this type of fund would be one that invests in the S&P 500 Index.

Synthetic ETFs are slightly more complex in that they harness derivatives contracts in an attempt to fulfill their investment objectives. It is important to note that these financial instruments are subject to the same risks as physical ETFs, but if you buy one, you must also consider that they are susceptible to counterparty risk, which is the risk that one of the contract holders of the derivatives used will default on its responsibilities.

ETFs and portfolio management
If you want to harness ETFs, you should know that they can be used effectively in portfolios, and can be harnessed to diversify your existing assets. The idea behind diversification is combining different assets that do not follow each other in terms of their price movements any more than necessary. The idea is that if one component of your portfolio depreciates, the other ones will rise in value to compensate for this this decline in price.

Since you can use one of these funds to quickly gain exposure to a group of assets, for example a wide range of U.S. stocks, you can use ETFs to construct a diversified portfolio for more quickly than you could if you wanted to pick out individual stocks one by one.

ETN basics
One major difference between these funds and ETNs is that while the first financial instrument was created under the provisions set forth by the Investment Company Act of 1940, the second was designed under the Securities Act of 1933, according to Zacks.com.

What this means for you is that while in the eyes of the law, an ETF is an investment company, an ETN is a debt-based financial instrument. Since these notes are issued by a participating financial institution, the buyer must consider the risks associated with that entity, the media outlet reports. If you are considering an ETN, keep in mind that if the credit rating of the issuer is lowered, it can impact the financial instrument, according to Stock Trading to Go.

At this point, you may be wondering why you would want to invest in one of these notes instead of simply purchasing an ETF. One distinct benefit of ETNs is that they are far more precise in following the price movements of their underlying assets, the media outlet reports. In addition, while ETFs are subject to taxes caused by capital gains and distributions, ETNs only generate tax liability when they are sold.

If you want to learn more about these securities, there is free trading education available through TradingPub, home to some of the top investors and traders in the industry.