ETNs: Handle With Care

Exchange-traded notes are not for the untutored.

Fragile Label on cardboard box

Over the past 20 years, investors who were once trapped in the cumbersome, relatively expensive vehicle that is the mutual fund have moved in droves to the more flexible realm of the exchange-traded fund, which features lower expenses and intraday trading. But ETFs come with certain drawbacks, such as taxable distributions and "tracking error"—discrepancies between a fund's value and its underlying index.

One solution to those problems is the ETN, or exchange-traded note, a relatively new product that combines characteristics of bonds and ETFs. It offers intraday trading, is theoretically immune to tracking error, and provides access to asset classes that are otherwise difficult for average investors to buy.

[See Should You Have Alternative Investments in Your Portfolio?]

But ETNs also come with a different set of risks, not the least of which is complexity that can make them inappropriate for anyone who's not a fairly sophisticated investor.

The most important difference between ETNs and ETFs is what they represent. An ETF, like a mutual fund, holds a basket of securities that the ETF holder, of course, owns indirectly. When you buy an ETN, by contrast, you are not buying a bundle of securities; you are lending money to the bank that issues the ETN, and your loan is unsecured. It's an elaborate IOU.

Unlike conventional loans, though, ETNs do not pay periodic interest. Instead, the issuing bank promises to pay you on a maturity date (generally 15 to 30 years out) the return of a benchmark index, minus fees.

The first ETN was offered by Barclays in 2006, launching what has become the iPath family of ETNs investing in everything from commodities to currencies. Today, Lipper counts 212 ETNs, only about half of which reported fund values as of July 31. That figure totaled $14.2 billion, so even if the true total is twice that, ETNs represent a small fraction of the $1.2 trillion held in exchange-traded products, most of that in ETFs.

So why would you want to buy an ETN at all? They offer a certain predictability—as long as the issuer stays afloat. Whereas an ETF represents a pool of securities whose value can be all over the place while you own it, an ETN is simply a promise to pay you the value of an index at some future date.

"The investor is not going to outperform the index in an ETN," says Garrett Stevens, CEO of Exchange Traded Concepts, which helps financial institutions bring ETFs to market. "That's not the goal in an ETN. The goal in an ETN—and in an ETF, for that matter—is to do exactly what the index is doing, not better or worse."

Stevens means passive ETFs. There are active ETFs that do try to beat their indexes, and like any active mutual fund, they can either outperform or underperform the index. By contrast, says Stevens, "when you buy an ETN, you know what you're getting. An ETN is a contractual obligation to pay what this index is doing, less the management fee."

[See Don't Fall for Exotic Investments.]

Another benefit: access to assets not normally available to the average investor, like foreign equities, currencies, and, mainly, commodities. Examples run the gamut from the iPath Pure Beta Coffee ETN (symbol: CAFE) to the Velocity Shares 2x Inverse Platinum ETN (IPLT). The principle is the same. In a corn ETN, says Stevens, "you're going to do whatever corn does, minus the management fee, and you know that going into it."

Most observers agree that ETNs offer a tax advantage, in that there are no periodic income or capital distributions, and gains are treated as capital gains, which can carry a low 15 percent federal tax rate for holdings of more than one year. Warning: That seems to be more a matter of informal agreement than anything else. The IRS and Treasury are reconsidering the way ETNs are taxed (check your prospectus).

Of course, there are risks. The most obvious is market risk: The underlying index could fall over time."Leveraged" and "inverse" ETNs—which, like their ETF counterparts, attempt to amplify the performance of, or bet against, the underlying index—carry even greater market risk. Because of the way the math works on a leveraged ETN (as with a leveraged ETF), short-term volatility can kill you even if you're right about the long-term direction the market.