With over $1 trillion in assets, investors are betting with their wallets that exchange traded funds (or ETFs) are an excellent investing vehicle. Basically, exchange traded funds are baskets of investments – which range from stocks, bonds and even commodities.
But there is confusion about how ETF funds differ from ETN investments. ETN stands for exchange traded note, rather than exchange traded fund.
For the most part, an ETF is based on an index like the S&P 500 or Thomson Reuters/Jefferies CRB Index. Because of this, the fees tend to be low and so is the portfolio turnover. The result is that the tax hit is usually lower (in terms of capital gains distributions). Another nice feature is that you can buy and sell an ETF fund throughout the trading day. In fact, it is even possible to borrow against the securities and short them (which means making money when the value of the investment falls).
ETN investment is similar to ETF investment in terms of daily trading, borrowing against the assets and tracking indexes. However, there are some big differences. For example, an ETN is an unsecured debt of a financial institutions. So think of it as a loan in exchange for a basket of investments – not a fund of component stocks or assets.
This is important since an ETN will typically track an index more accurately than an ETF. There is also a nice tax advantage, in which there is no capital gains distributions until the sale of the ETN.
OK, so what is the hitch? Well, since an ETN is a loan, there is a possibility that you may not get your investment back if the financial institution fails. This is why it is a good idea to focus on ETNs of large companies, with strong long-term track records (although, as seen with Bear Stearns and Lehman Brothers, this is not easy to know).
Interestingly enough, ETN investments are getting more popular. According to ETF Trends, there are 135 U.S. listed ETN flavors, which have nearly $16 billion in assets.
Let’s take a look at 5 of the largest ETN investments out there:
iPath S&P GSCI Crude Oil TR Index ETN (OIL)
The iPath S&P GSCI Crude Oil TR Index ETN (NYSE: OIL) tracks the price of light, sweet crude oil. This is done by purchasing futures contracts, which allow for the delivery of the commodity at a later date.
Unfortunately, in some cases, the markets may go into contango – which means the current price is lower than the futures prices – and this can mean that an ETN can lag. But as for the iPath crude oil ETN, it has tracked the spike in oil fairly well. The price of the security has gone from $23.23 in mid February to $27.81.
iShares Dow Jones US Financial Sector (IYF)
Just a couple years, it looked like the financial system was about to implode. But with a huge federal bailout, there has been a turnaround. And it may still be in the early stages, especially as the U.S. economy comes back.
One ETN that taps into this trend is the iShares Dow Jones US Financial Sector (NYSE: IYF). It tracks an index of over 250 financial services firms, which span categories like banking, insurance and mortgages.
For the most part, the Financial Sector ETN focuses on high-quality issues. The top holdings include JP Morgan Chase (NYSE: JPM), Wells Fargo Company (NYSE: WFC), Bank of America (NYSE: BAC), Citigroup (NYSE: C) and Berkshire Hathaway (NYSE: BRK.A, BRK.B).
iPath MSCI India Index ETN (INP)
Since moving away from socialism in the early 1990s, India has been a strong growth story. While the it is no longer in the double-digits, it is still impressive. Keep in mind that the economy grew 7.4% during 2008, when there was a global recession.
To participate in the growth, there is the iPath MSCI India Index ETN (NYSE: INP), which has $798 million in assets. It is based on the MSCI India Total Return Index (composed of 60 companies). The industry categories range from financials, information technology and energy.
iPath DJ-UBS Commodity Index TR ETN (DJP)
If you take a look at a list of ETNs, you’ll notice that many are focused on commodity markets. Then again, an ETN structure is a good choice for investments that are based on futures contracts.
The largest commodity-based ETN is the iPath Dow Jones-UBS Commodity Index TR ETN (NYSE: DJP). It has $3.2 billion in assets.
All in all, the Dow-Jones-UBS ETN is a good way to get exposure to commodities, since it has positions in 19 categories. Some include energy, agriculture, precious metals, livestock and so on.
iPath S&P 500 VIX Short-Term Futures ETN (VXX)
There seems to be no end to market volatility. Of course, the latest events involve things like radiation disasters as well as instability in the Middle East.
But interestingly enough, there is an index that increases in value when there is volatility. It’s called the VIX index, which is based on the swings in the S&P 500 (another name for it is the “fear index”).
And yes, there is an ETN for the VIX: the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). Now doubt, the VIX was one of the best-performing investments in 2008, hitting a record of 80.