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Thursday, November 11, 2010

WTF is an ETN ?

By now most investors are familiar with the concept of an ETF or exchange traded fund. It seems that ETF’s are like the weeds of the stock market a new one pops up every day and there seems to be an ETF for anything you can think of from financials to commodities and everything in between; in fact I would not be surprised to find them issuing an ETF for the porn industry (NYSE:SEX) and market it claiming it always rises or some such rubbish. ETF’s are actually a very useful investment vehicle and can have a home in virtually any portfolio.

For those of you who do not know what an ETF is, think of it as a mutual fund that trades on an exchange like a stock. An exchange traded fund can be broad in nature and track the S & P 500 (NYSE:SPY) or the NASDAQ Composite (NASDAQ:QQQ) or it can be very focused like the Powershares Water ETF (NYSE:PHO) or SPDR Gold Trust (NYSE:GLD). ETFs offer the investor the opportunity to diversify as well as target certain areas of the market or economy that might outperform. In recent years ETFs have given investors even more access to commodities and currencies areas that John Q did not have easy access to in the past. Today you can log on to your brokerage account and with the click of a mouse diversify your portfolio or go long the Yen, Short the Pound, buy silver or sugar ; in fact the options have become almost mind boggling.

Dear reader you may be asking yourself why is this any better than a mutual fund, a good question. Some of the advantages of an ETF over a mutual fund are lower costs, transparency and liquidity. As I mentioned and ETF trades like a stock on an exchange so it can be bought or sold as long as the market is open and will be filled just as quickly as a stock transaction; a mutual fund by contrast will take your order but perform your buy or sell transaction after calculating the NAV (Net Asset Value) once the market has closed.  Moreover, ETFs tend to carry far lower management fees than mutual funds of the same variety which can impact your return substantially especially over time; if you are diversifying by trying to mirror an index like the S & P 500 does it make sense to pay a hefty management fee for a mutual fund when an ETF like the SPY will perform equally well with far lower holding costs? As for transparency the holdings of ETFs are listed on the web in various locations and are updated frequently where as mutual funds tend to release holdings information in prospectuses that are out dated and this can make it difficult to know what you are holding. Knowing what your funds are holding is important because you want to make sure that your funds are invested in assets or areas that you think will perform well and you want to make sure your holding are not redundant as this can add risk.

So dear reader you now have heard me blather on about ETFs but my headline mentioned ETN’s and you are asking yourself WTF is the difference; I will try and explain. Most people see an ETN like I-Path DJ-UBS Copper Total Return Sub Index ETN (NYSE:JJC) which tracks the price of high grade copper futures on the New York Commodities Exchange. If you look at JJC it has done very well as copper prices have rallied thanks to the FED’s QE policies.

Even though an ETN like JJC trades on an exchange and shares many of the same characteristics of an ETF it is fundamentally different in some respects. As an ETN this security is really a bond not a fund yet it pays no interest instead your interest is the return on the underlying index or commodity. While you are able to participate in markets like the copper market with JJC since it is designed to track the copper market without, you dear reader, having to use or understand complicated and risky instruments like futures. You need to understand that when you plunk your hard earned cash to buy shares in JCC you are not actually buying copper. Instead you are buying the Barclays Bank’s promise that they will pay you a return as measured by the underlying index, the Dow Jones UBS Copper Index. So in essence dear reader by purchasing this ETN you have become an UNSECURED CREDITOR of Barclay’s Bank. Just like many things in life there are no guarantees and for this security to work and retain value requires that Barclays Bank Stand behind it. If Barclays should run in to trouble then your investment could be at risk even if it is unrelated to the ETN itself. This means if hypothetically that a rogue trader was to place some bad trades in one of Barclays other divisions and brought the company to its knees, I know that would never happen, then you would have to stand in line behind lots of other creditors as a bankruptcy judge carved up the distribution of Barclays remaining assets. That does not sound like a thrilling proposition especially when it is your capital we are talking about.

In contrast ETFs are fall under the prevue of the Investment Company Act of 1940, which requires that ETFs are chartered as separate corporations of which you are purchasing shares. An ETF will have a board of directors and a manager to keep everything on the straight and narrow. Moreover if the parent company for an ETF such as HBSC for the SPDR Gold ETG (NYSE:GLD) went belly up the fund and its holders would be unaffected from an investment loss perspective since it is its own company. Even if HBSC were liquidated the fund would continue operations and not be subject to the bankruptcy arena. There is a slight potential for disruption as the board may seeks a new manager but the underlying assets and your investment is not in harm’s way.

Most investors have no idea about the difference between an ETF and an ETN so now you are ahead of the game. To me the failure of the industry to educate investors about the various investment vehicles is a prime example of the SEC (Securities and Exchange Commission) being asleep at the switch. Many investors don’t even realize that they may be potentially increasing their risk by playing with these ETNs which are essentially derivative bonds. By derivative, I mean that the value of the bond is derived not by owning the underlying asset but an institution’s promise to pay against an index that tracks the actual asset. Investors that buy an ETN take on extra risk versus an ETF which most if they knew would not do. An investor has to be willing to take on market risk like all investments but also adds corporate risk as well. If you don’t think it is an issue just remember that we are living in precarious times and even the too big to fail can fail. Remember 2008 when Lehman went under they had ETNs such as, Opta Lehman Brothers Commodity Index Pure Beta Total Return ETN (RAW) and it went in to legal limbo. For a period of time it appeared that Barclays was going to pick up the ETNs from the Lehman debacle but ultimately they passed on this liability. The investors in this ETN suffered a total loss. The lesson is if you are going to buy and ETN realize you are taking on extra risk and make sure you check the credit rating and stability of the issuing company. ETNs are a true case of caveat emptor, “buyer beware”, and shame on the securities industry for not educating the “sheeple” but herding them instead.

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