Want ETNs? Do Homework First

11/19/2012


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.

10 SELECT EXCHANGE-TRADED NOTES
Exchange-traded notes (ETNs) typically invest in the more obscure corners of the market and often expose investors to heightened risk. Most investors should view ETNs as specialized, niche securities.
--- Total Return ---
ETN (Price; Ticker)
YTD
(%)

3-Yr.
Ann.
(%)

Expense
Ratio
(%)
What It Tracks
iPath DJ-UBS Agriculture
($57; JJA)
6.1
9.4
0.75
7 agricultural
commodities
iPath DJ-UBS Commodity
($42; DJP)
(1.1)
1.5
0.75
19 broad commodities
iPath DJ-UBS Grains ($55; JJG)
23.0
11.6
0.75
Soybeans, corn,
and wheat
iPath DJ-UBS Livestock
($28; COW)
(5.0)
1.0
0.75
Hogs and cattle
iPath DJ-UBS Natural Gas
($3; GAZ)
(15.1)
(37.4)
0.75
Henry Hub
gas futures
iPath S&P 500 VIX ST Futures
($35; VXX)
(75.5)
(63.1)
0.89
CBOE volatility
futures
iPath S&P GSCI Crude Oil
($21; OIL)
(18.4)
(7.4)
0.75
West Texas
Inter. (WTI) oil
J.P. Morgan Alerian MLP Ind.
($39; AMJ)
3.3
19.7
0.85
50 limited
partnerships
UBS E-TRACS CMCI Gold
($46; UBG)
9.6
14.4
0.30
Gold futures
contracts
UBS E-TRACS CMCI Silver
($45; USV)
15.9
21.6
0.40
Silver futures
contracts

The top above lists 10 ETNs that might appeal to aggressive investors. All of the notes, which cover 10 popular market segments, have three-year track records and reasonable expense ratios. One notable exchange-traded note, the J.P. Morgan Alerian MLP Index ETN ($39; AMJ), tracks the performance of an index of 50 master limited partnerships (MLPs).

OUR RECOMMENDED MUTUAL FUNDS
Through Nov. 13, our Growth Portfolio has gained 10.0% for the year, versus a 10.3% gain for its benchmark portfolio. The Conservative Portfolio is up 9.5%, versus 8.7% for its benchmark.
-- Year-To-Date --
--- % Of Portfolio ---
 
Fund (Price; Ticker)
Return
(%)
Rank
Conser-
vative
(%)
Growth
(%)
Fund
Rating
Dreyfus Midcap Index ($29; PESPX)
10.7
B
0
0
81
Dreyfus Small Cap Stock Index
($21; DISSX)
8.0
C
0
0
91
Fidelity High Income ($9; SPHIX)
12.2
C
5
5
92
Homestead Small Company
($26; HSCSX)
11.9
A
7
8
99
Manning & Napier International
($8; EXITX)
8.2
D
7
7
57
T. Rowe Price New Horizons
($34; PRNHX)
10.0
A
10
10
99
Vanguard 500 Index ($127; VFINX)
11.3
B
6
7
81
Vanguard Dividend Growth
($16; VDIGX)
6.6
E
12
12
96
Vanguard Emerg. Mkts. Stock Indx.
($26; VEIEX)
9.2
C
0
4
67
Vanguard GNMA ($11; VFIIX)
1.9
D
5
4
84
Vanguard Growth Index
($35; VIGRX)
12.3
B
12
12
98
Vanguard Inter.-Term Tax-Exempt
($15; VWITX)
6.2
B
0
0
74
Vanguard Selected Value ($21; VASVX)
11.1
C
5
6
93
Vanguard Short-Term Invest.-Grade
($11; VFSTX)
4.4
B
0
0
91
Vanguard Total Bond Mkt. Index
($11; VBMFX)
4.4
E
9
0
32
Vanguard Total Int'l Stock Index
($14; VGTSX)
9.2
C
5
4
65
Vanguard Wellesley Income
($24; VWINX)
9.0
A
0
0
100
Vanguard Wellington ($34; VWELX)
9.7
B
6
9
95
Wasatch International Growth
($22; WAIGX)
25.5
A
5
5
100
Wells Fargo Advantage Discovery
($25; STDIX)
10.0
B
6
7
91
* Year-to-date ranks through Nov. 13 from Morningstar, comparing performance among funds with same objectives. A = top 20%; B = next 20%; C= middle 20%; D = next 20%;
E = bottom 20%. Fund ratings are percentile ranks based on our fund-rating system.

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