ETF Alternatives: Venture into Exchange-Traded Notes - dummies

ETF Alternatives: Venture into Exchange-Traded Notes

By Russell Wild

Exchange-traded notes (ETNs) sure sound like exchange-traded funds, and the two do have some things in common. But they also have one or two big differences. The commonalities include not only their names but the fact that both ETFs and ETNs trade throughout the day, they both tend to track indexes, and they both can be tax efficient — especially the ETNs.

Given these commonalities, the term exchange-traded products or ETPs has been used to describe both ETFs and ETNs, as well as closed-end mutual funds.

The big, big, BIG difference between ETFs and ETNs is this: An ETN is a debt instrument. In other words, a firm like Barclays, which issues the iPath ETNs, promises to pay holders of its ETNs a rate of return commensurate with some index.

For example, the iPath DJ-UBS Tin Subindex Total Return ETN (JJT) promises to pay you according to how much the price of tin goes up (or down), minus fund expenses.

Whether Barclays actually invests your money in tin, or in Treasuries, or in whatever the heck it wants, is up to Barclays. The company simply made you a promise to pay, just as if you held one of its bonds.

An ETN is more like a bond, really, than an ETF. Instead of a fixed rate of interest, however, you get paid according to some other measure, often the change in price of a commodity or in a foreign currency relative to the dollar.

If all goes well (and the price of tin or the value of the Euro goes up), you get your money. But if something should happen to Barclays, you could lose everything. Your capital is not guaranteed, regardless of what happens in the commodity or currency markets.

So quite clearly, you should buy ETNs only from solid companies, and you should never hold too much of your portfolio in any one ETN or group of ETNs issued by any one company.

The advantage of ETNs is that they can be even more tax efficient than ETFs, especially where commodities are concerned. Many ETNs invest (well, sort of) in either a single commodity or a basket of commodities, and you might consider such a commodity ETN if you want to tap into this asset class.

Because commodity ETNs are more tax-efficient than commodity ETFs, you may especially want to choose an ETN over an ETF if you have limited room in your tax-advantaged accounts and need to put commodities into a taxable account. ETNs also spare you the agony of having to file special K-1 tax forms that you generally need to file when you own commodity ETFs.

As for the currency ETNs, unless you know a whole lot more about currency exchanges than the average person, you’re likely to take a bath. Steer clear of these funds. They are expensive. They are volatile. And they are unpredictable. Currency ETNs, alone among ETNs, are not even all that tax efficient; you’ll likely pay regular income tax on any gains, should you be so lucky as to have them.

ETNs that are not speculating in currencies and not tracking commodity indexes are typically offering you the “opportunity” to double or triple your money in a hurry with leveraged strategies. Or they are employing leveraged “inverse” strategies, promising you big money in a bear market. Do yourself a big favor and stay away from these.