All exchange-traded products aren’t created equal; different structures create advantages and disadvantages. I’ve received many questions about the difference between exchange-traded funds (ETF) and exchange-traded notes (ETN). We’ve entered the season when brokers send tax information to clients and many investors have been surprised by their tax bills. This confusion may stem from a lack of familiarity with the exchange-traded product in their portfolios.

Most readers are familiar with the ETF structure. Exchange-traded funds are set up much like traditional mutual funds. Their shares represent a fraction ownership interest in a basket of underlying securities such as stocks, bonds, futures or other investment vehicles. But unlike ordinary mutual funds, ETFs are generally more tax efficient because they don’t result in unanticipated taxes on capital gains. Investors are usually only subject to capital gains taxes when they sell their shares in an ETF; the trading activities of other investors won’t trigger a tax bill.

If the ETF you own collects dividends from its underlying holdings that are considered qualified, and then the ETF passes that dividend on to investors, shareholders will pay the qualified 15 percent tax rate. All of that information is reported on the 1099 form you receive from your broker.

Exchange-traded funds have another advantage. If an ETF is wound down because its sponsor has gone broke, investors usually have to worry about little more than the tax bill. That’s because ETF assets are segregated from the firm that runs the fund; when trading stops, investors receive a cash distribution of the net asset value of the shares they own. Since that would be considered a taxable event, you’ll have to pay whatever taxes are due. But you won’t lose the value of your investment.

On the other hand, ETNs are an entirely different beast.

Structured as a debt instrument, ETNs are basically an agreement by a major bank such as Barclays (NYSE: BCS) or JP Morgan Chase (NYSE: JPM) to pay out the performance of an index, minus a fee for its service.

As a result, ETNs tend to produce almost no tracking error relative to their benchmarks (save for a small underperformance due to the fee), which can make them extremely attractive to investors. But there are some unique risks and drawbacks associated with ETNs.

The most obvious risk is credit related. Exchange-traded notes are set up as junior, unsubordinated debt agreements. This means that if the bank backing the notes goes bust, investors are left holding the bag. They’ll most likely recover none of the principal.

Taxation is another major drawback. Exchange-traded note investors shouldn’t receive unexpected taxes on capital gains, but distributions from ETNs are typically taxed at much higher ordinary income rates, rather than treated as qualified dividends.

Finally, most ETNs are structured as partnerships. Investors receive a K-1 form every year at tax time rather than the 1099 form that is more commonplace. Most tax professionals and tax software packages can easily handle K-1s, but they can be intimidating at first glance.

Exchange-traded funds and ETNs have separate virtues and drawbacks. But investors should be aware of the key differences between these two investment vehicles–particularly as they relate to taxes–when they make their investment decisions.  

What’s New

Two ETFs launched last week.

First Trust NASDAQ CEA Smartphone Index (NYSE: FONE) is little more than a gimmick. First Trust began the filing process with the SEC last August to bring the fund to market. But the timing of the launch aims to capitalize on the rally we’ve seen in smartphone-related companies.

It’s no surprise that an ETF would try to take advantage of the smartphone boom–sales of smartphones are expected to outpace personal computer sales next year. But the beginning may also signal the end of the boom days; an ETF launch is one sign that a trend has already matured. Nevertheless, First Trust NASDAQ CEA Smartphone Index is the only pure play smartphone ETF and should draw investors willing to bet on this trend.

Global X’s Global X FTSE ASEAN 40 (NYSE: ASEA) is a truly useful offering. Replicating an index that tracks the largest companies in Indonesia, the Philippines, Singapore, Malaysia and Thailand, the fund offers unique exposure to five of the fastest growing emerging markets. All five nations benefit from strong trade with China, low labor costs, and liberal, Western-minded economic policies.

It usually doesn’t pay to be an early adopter of an ETF. Global X FTSE ASEAN 40 is no exception to the rule–the fund’s average daily volume stands at about 25,000 shares. But expect this ETF to find a place in many investors’ portfolios.