WTF is an ETN?

A typical phenomenon that occurs around the New Year is the financial media's prognostications related to the coming year from an investment standpoint. Due to the rise of the internet information is quite free flowing and readily accessible. Additionally, the internet allows just about anyone with a computer to express their opinion or predictions to a mass audience, which is a good thing because it can make you think differently or provide a perspective that may not have been considered.

This freedom to publish predictions by anyone on the internet also has a downside since many of these same people may have an agenda and or be misinformed; there are also people that will invest their hard earned capital based upon theses missives. It always amazes me that people will agonize and research various objective sources before they go out and buy a dishwasher, car or TV; but when it comes to the markets they will read an article and treat it as gospel by which they plunk down their cash. It is my belief that the mass of investors do this since the market is purposely made to seem confusing and irrational so rather than do the hard work and take responsibility for your losses people want to have a scapegoat for when their investments sour. Of course, if they get lucky and their investment prospers they will be more than happy to take credit for that just like Wile E. Coyote “super genius”. Yes, the market can be irrational short term and one can make money correctly predicting the wiggles and gyrations, however, this is the reason I prefer to look at broader trends.

The markets tend to play out broad trends over longer periods, so if you can identify a trend you can ride it. This is not to say that just because the broad trend is in place you cannot have a bumpy ride; just look at the precious metals and commodity space for an example. Over the longer term the current down draft in the precious metals and commodities will be just blip on the radar as nothing has really changed regarding the drivers of both bull markets, however, if you ride those markets it feels pretty lousy now. Of course there are various hedging strategies that can be used to offset at least some of the volatility and there are even ETF's to aid you in that endeavor.

Despite what is going on today the past year was a good one in commodities and precious metals for a variety of reasons, although they are taking a break at the moment. The run in commodities in particular has sparked a boom in exchange traded investments that track a variety of both hard and soft assets. These new investments are great if you are a trader or want to give your portfolio exposure to a specific area or commodity, but it is not a panacea and can dramatically increase your portfolio volatility and risk.

Getting back to the New Years predictions I noticed that many of them are calling for investing in very specific areas using targeted vehicles. My concern regarding this strategy for inexperienced investors, of which there are many, is twofold. First, through various conversations it has become obvious to me that many intelligent people do not understand the structure of the vehicles in which they are they are investing. Second, these same people do not get the diversification that they need because they tend to place too large a chunk of their assets in the aforementioned risk vehicles.

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 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 SPY or the NASDAQ Composite QQQ or it can be very focused like the Powershares Water ETF PHO or SPDR Gold Trust 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 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, the investor, 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 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 buy 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", “Let the buyer be beware”, and shame on the securities industry for not educating the “sheeple” but herding them instead. P.S. Following up on a couple prior articles: 1) Intel INTC stock has stabilized and appears to be attempting to push higher after settling a patent dispute with WiLan Corp. of Canada and announcing another $10 Billion in stock buybacks. 2) Stonmor LP STON Pulled back to its 50 day moving average on high volume on no news and has subsequently bounced back in to its uptrend; I was fortunate enough to acquire some shares at $30.25. 3) Thompson Creek TC the Molybdenum producer pulled back in its uptrend in to my buy range and is bouncing off its 50 day moving average as well.

I post this column on Thursdays here at Benzinga although I do have my own blog (monetaadvisors.com) where I cover stocks, commodities, precious metals, currencies, markets, government and interesting general observations that may not get play on Wall Street as well as subjects that interest me and hopefully you too. I also have a Twitter Feed @monetaadvisors if you are interested. I am a Series 65 Investment Advisor Representative and have recently started my own investment advisory called Moneta Advisors, LLC, based in the Boston area. I have been through a series of careers from which I have learned many useful things along the way. In my past I have been a stockbroker, computer programmer, Sr. computer consultant, and ran a manufacturing company; all the while I remained a private investor.