Beware ETNs: Risky ETF look-alikes

@Money May 24, 2012: 2:03 PM ET
ETNs, or exchange-traded notes, are catching on but they carry many more risks than ETFs.

ETNs, or exchange-traded notes, are catching on but they carry many more risks than ETFs.

(MONEY magazine) -- Once again, Wall Street is turning a good idea into a lousy deal.

That's the case with exchange-traded notes, or ETNs. Like exchange-traded funds (ETFs), their older and better-known siblings, ETNs are portfolios of stocks, bonds, or other assets that you can buy and sell throughout the day.

ETNs are catching on fast, as financial services firms push them as a more tax-efficient way to buy alternative assets, such as futures and commodities.

"Because they look similar to ETFs, many investors probably own ETNs without realizing the difference," says Matt Hougan, editor of IndexUniverse.com, which tracks ETFs and ETNs.

It's time to take a closer look. Fact is, ETNs are very different -- and they carry many more risks. Here's what you need to know:

ETNs are less investor-friendly.

When you buy an ETN, you aren't investing in a fund. You're buying an unsecured debt obligation -- in effect, a promise to deliver a return -- and you are counting on the stability of the sponsor. (That didn't work out well for investors in ETNs issued by Lehman Brothers.)

You also don't have fund-like investor safeguards, such as standardized disclosure or a board of directors tasked with looking out for shareholders.

Expenses are often steep -- and hidden.

If you look up an ETN on Morningstar.com or CNNMoney.com, you'll see a fee listed. That's not the whole story. ETNs may calculate expenses differently or levy more charges -- then bury that information in a pricing supplement to the prospectus.

"ETN fees can be extremely hard to find and calculate," says Morningstar ETF analyst Samuel Lee.

Take the iPath DJ-UBS Commodity Index (DJP), which has a 0.75% fee. Unlike regular expense ratios, which are calculated daily, DJP's fee is based on a weighted average of the index values since the ETN's launch, says Lee.

So you can end up paying a high amount based on past gains, even if recent performance is poor (the inverse is true too). Those higher fees can create a divergence between the return of the index that the ETN tracks and what you actually earn. Last year the gap for DJP was 1.27%, not the 0.75% you'd expect.

Looks may be deceiving.

ETNs have become the go-to option for complex alternative investments, such as the VelocityShares Daily 2X VIX Short-term (TVIX), which promises returns based on the VIX, an index of market volatility. But the ETN is actually for daily traders. Longer-term investors got a shock when the price recently diverged from the index after the sponsor, Credit Suisse, stopped and then resumed creating shares.

The one thing you can know for sure is that ETNs usually make money for the companies that offer them. For investors, not so much. Until ETNs become more shareholder-friendly, steer clear.

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