When Exchange-Traded Notes Trump Exchange-Traded Funds

ETNs offer access to unusual strategies, but be aware of their special risk.

On the surface, exchange-traded notes appear similar to their more popular cousins, exchange-traded funds. Both seek to match some sort of market barometer, and both offer similar advantages over actively managed mutual funds: lower fees, lower investment minimums and greater tax efficiency. And, like stocks, you can trade them throughout the day.

But don’t be misled. ETFs and ETNs are very different animals. ETFs mimic the indexes they track by holding a diversified collection of securities, such as stocks or bonds. ETNs, however, don’t own anything. An ETN is an unsecured debt that is typically issued by an investment bank. Like an ETF, an ETN tracks an index. But when you invest in a note, you’re merely buying a promise from the issuer to pay you the index’s return, minus fees.

So when you buy an ETN, you not only take a chance on whatever index the note seeks to copy, you also assume the risk that the issuer could fail to make good on its promise. Investors in three ETNs sponsored by Lehman Brothers got a taste of that sort of risk after Leh­man went belly up in 2008. So far, none of its creditors, including its ETN investors, has received a penny.

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So Why Buy ETNs?

Even with all that extra risk, notes do have some advantages. For starters, ETNs offer access to hard-to-reach asset classes and investment strategies (we’ll discuss some of them later). Moreover, although ETFs are subject to tracking error -- that is, the chance that the fund will not move precisely in sync with the index it’s designed to match -- ETNs are not.

ETNs are also more tax-friendly than ETFs. ETFs, like mutual funds, must distribute annually to shareholders all the interest and dividends they collect from the securities they hold. Investors who receive these distributions in taxable accounts must share their earnings with the IRS at rates as high as 35%. An ETN, by contrast, reflects the collection of dividends and interest by adjusting its net asset value, so you don’t pay taxes until you sell the ETN. And if you hold an ETN for more than a year, you pay the long-term capital-gains tax rate of 15%.

Commodity-oriented ETNs also have a tax edge over similar exchange-traded products. With a commodity ETN, you pay taxes when you sell, allowing you to pay the favorable capital-gains tax rate if you hold the ETN for more than a year. Most exchange-traded commodity funds invest in futures contracts and are set up as limited partnerships. That means investors have to tackle potentially complex Schedule K1 forms. Moreover, you must pay taxes on any capital gains the ETF realized during the year, even if you didn’t sell any shares. In addition, ETFs that hold precious metals, such as gold, are taxed as collectibles, at a maximum rate of 28%, not 15%. (Currency ETNs don’t have the same advantage as other ETNs; interest from these ETNs is taxed as ordinary income on an annual basis.)

4 ETNs Worth a Look

In each case we list below, the ETN either offers advantages over comparable ETFs or provides a strategy that is unavailable with an ETF.

Commodities. Because of the tax pluses, investors may find Elements Linked to the Rogers International Com­modity Index -- Total Return (symbol RJI (opens in new tab)) the best way to invest in stuff. Issued by the Swedish Export Credit Corp., RJI is the fourth-largest ETN in the U.S., with $919 million in assets. It follows a benchmark of 38 commodities created by Jim Rogers, a commodity expert and author. The index has a 44% weighting in energy, 35% in agricultural products and 21% in precious and base metals. Over the past year, the ETN returned 40.4%, compared with 37.9% for PowerShares DB Commodity Index Tracking Fund (DBC (opens in new tab)), the largest commodity-oriented ETF (all returns are through June 3). The ETN’s annual expense ratio is 0.75%.

Master limited partnerships. MLPs are publicly traded limited partnerships that are usually tied to natural resources. They can make large payouts to investors because the partnerships don’t pay corporate income taxes. MLP investors pay taxes on the distributions and may also have to contend with K-1 forms from the partnerships. In addition, investors may have to pay taxes in every state where an MLP does business. The idea of letting an ETF deal with all the MLP hassles sounds appealing. But to be able to invest exclusively in MLPs, an ETF needs to be structured as a corporation -- and pay corporate taxes.

ETNs that focus on MLPs avoid tax complications, and they make regular cash distributions, which are taxed as ordinary income. A good choice is Credit Suisse Exchange Traded Notes Linked to the Cushing 30 MLP Index (MLPN (opens in new tab)). It tracks an index of 30 MLPs involved in the processing, transportation and storage of oil and gas. The index assigns each MLP an equal weighting and rebalances the holdings quarterly. Over the past year, the ETN, which charges 0.85% annually, gained 28.6%.

Options strategy. Owning a stock and selling call options against it lets you boost income while capturing some of the stock’s potential appreciation (a call option gives you the right to buy a stock at a certain price by a certain date). The strategy, known as covered-call writing, often outpaces a diversified bundle of stocks in a flat market, though it will lag in a powerful bull market. The iPath CBOE S&P 500 Buy Write Index ETN (BWV (opens in new tab)) lets you undertake this strategy for the broad U.S. stock market. The index assumes the purchase of all the stocks in Standard & Poor’s 500-stock index and the writing, or selling, of call options against each of them. Over the past three years, the ETN lost 1.3% annualized, while the S&P 500 gained 0.3% annualized. But during the 2008 disaster, the ETN fell 30.2%, compared with the S&P 500’s 37% tumble. The ETN charges 0.75% (iPath ETNs are issued by Barclays Bank).

Betting against bonds. ETNs can counteract one of the main problems with inverse ETFs, which seek to return the opposite of an index: Such funds meet their objective only on a daily basis. Because of the peculiarities of performance math, you can potentially lose money in an inverse fund over extended periods even if you guess correctly on the trend. An inverse ETN is designed to overcome that flaw. For example, if you think interest rates are heading up (and bond prices, which move opposite to rates, are heading down), consider iPath US Treasury 10-year Bear ETN (DTYS (opens in new tab)). The ETN, which closed June 3 at $45, is designed to gain $10 per share for every one-percentage-point rise in ten-year Treasury yields. So if the yield on the ten-year Treasury, now 3.0%, climbs to 4.0%, you’ll earn more than 20%. Of course, if the yield falls, you’ll lose.

Contributing Editor, Kiplinger's Personal Finance