ETFs & ETNs: Know What You're Buying

03/06/2013 9:00 am EST

Focus: ETFs

John Lounsbury of Investing Daily tells investors that not all exchange traded products are created equal.

First introduced in 1993, by the end of 2012 ETFs had attracted some $1.3 trillion in assets. Since then, investment banks have launched a slew of other exchange traded products that are substantially more risky that the standard ETFs, but whose downside is seldom made clear to retail investors.

One big source of potential confusion is ETNs (exchange traded notes). Introduced in 2008, these vehicles have already amassed some $500 billion in assets. But they are a far cry from ETFs.

Most ETFs replicate a specific bond or stock index, and they trade on a stock exchange. ETFs are popular because of their low fees, liquidity, transparency, and access to specialized indexes. ETFs can have different structures, affecting how they’re traded and taxed.

The oldest and largest ETFs were set up as unit investment trusts (UIT). UIT ETFs are required to fully replicate their underlying index, and may not “lend” out their shares to short sellers (to collect a fee in return). They also don’t reinvest dividends; they’re paid out to shareholders.

Examples include: SPDR S&P 500 (SPY), the very first and still largest ETF, and Invesco Power Shares QQQ (QQQ), which tracks the Nasdaq-100.
 
Most ETFs are open investment trusts. They don’t have to exactly replicate their index, as long as they track it very closely. They reinvest their dividends. And they can “lend” out shares they own to hedge funds or short sellers to collect a fee.

Examples include: Vanguard Emerging Markets ETF (VWO), the third-largest ETF; Vanguard Total Stock Market ETF (VTI), which tracks the entire US stock market; iShares iBoxx Investment Grade Corporate Bond Fund (LQD), the largest bond ETF; and Barclays TIPS Bond Fund (TIP), which tracks the Barclay’s US TIPS Index.

It’s worth noting that the second-largest ETF is now a commodity ETF, SPDR Gold Trust (GLD). The shares of this ETF represent claims on actual gold bullion, held in London vaults. ETFs that actually hold gold, silver, and other commodities are usually taxed at the same long-term gain rate as collectibles. Less-than-a-year gains are taxed as ordinary income.

Grantor trustssuch as PowerShares DB Commodity Index Tracking Fund (DBC) that use futures contracts are in a separate category. Taxes are due annually, based on a blended rate: 60% of gains are taxed at the long-term rate of 15 to 20%, and 40% of the gains are taxed at your ordinary income rate.

At year-end, investors are sent a Schedule K-1, instead of the more familiar 1099. To avoid higher taxes, many investors put grantor trust ETFs in tax-advantaged accounts such as IRAs.

ETNs are a different animal. ETNs are derivatives, as they are not an equity interest in anything. Like most ETFs, they track an index (often a commodity futures index). But unlike ETFs, they do not invest on your behalf in the assets that comprise that index.

Structurally, ETNs are debt securities with no collateral, and are not regulated by the Investment Company Act of 1940. As a result, ETNs could suffer losses should the sponsor go bankrupt.

Lehman Brothers and Bear Stearns had both issued ETNs when they went bankrupt in 2008. The Bear Stearns clients were rescued, but holders of the Lehman ETNs are unlikely to recover anywhere near their investment.

ETNs are thinly traded and often have larger bid-ask spreads than ETFs. ETN fees can be much higher than you think, and are often based on a scale that escalates over time. The pricing of the futures indexes many ETNs are based on is not easily accessible to the lay investor. ETNs in general have terrible long-term returns.

For the above reasons, ETNs should be used as trading vehicles by well-informed investors who have read the fine print in the prospectus.

Read more from Investing Daily here...

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