The Risks and Rewards of ETNs

11/27/2012 7:45 am EST

Focus: FUNDS

Richard Moroney

Editor, Dow Theory Forecasts

Exchange traded notes (ETNs) differ in significant ways from their exchange traded fund brethren, so it's crucial to know when to search them out and when to avoid them, advises Richard Moroney of Dow Theory Forecasts.

Feeling lucky? For adventurous investors, the potential for truly spectacular returns from exchange traded notes (ETNs) might seem irresistible. Yet to others, ETNs are just a recipe for disaster.

Provided you understand the risks and know what you are buying, ETNs make sense for some aggressive investors. For emphasis, we'll repeat the word aggressive.

From a distance, ETNs look similar to exchange traded funds (ETFs), as both typically mirror an index and trade on exchanges like stocks. On closer inspection, ETNs have a critical difference-they are debt securities issued by financial institutions that promise to pay investors the return of an index, minus any fees. While ETFs actually hold stocks, bonds, or commodities, ETNs do not own anything they track.

ETNs come with an added layer of uncertainty. Whereas ETFs are subject to market risk, ETN investors take on both market risk and credit risk. ETNs are essentially unsecured bonds backed by the financial strength of the issuer.

While nearly 210 ETNs trade, few make sense for even moderately conservative investors. Still, for at least three reasons, ETNs might be worth considering:

  • Expanded playing field. ETNs can better invest in strategies difficult or expensive to duplicate in an ETF. For investors seeking exposure to a narrow segment, particularly in commodities or currency, an ETN might offer the most attractive option.
  • Improved tax efficiency. Because ETNs do not own securities, they make no taxable distributions. Investors realize capital gains or losses only when an ETN matures or is sold. Many ETFs are subject to annual capital gains and income distributions.
  • Truer performance. ETNs minimize tracking error because the issuer promises to pay an investor the performance of an index after subtracting fees. In contrast, tracking error often becomes a problem for ETFs if they cannot hold all the components of their underlying indexes.

One notable ETN, the J.P. Morgan Alerian MLP Index ETN (AMJ), tracks the performance of an index of 50 master limited partnerships (MLPs).

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