Disclaimer: This article contains information that was factual and accurate as of the original published date listed on the article. Investors may find some or all of the content of this article beneficial but should be aware that some or all of the information may no longer be accurate. The information and/or data in this article should be verified prior to relying on it when making investment decisions. If you have any questions regarding the information contained in this article please call IFA at 888-643-3133.

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Exchange-traded notes (ETNs) are unsecured-debt instruments that track an index, currency, or a commodity price. According to Morningstar, there are now (as of 2/12/2012) 209 ETNs that hold a total of $17.4 billion in assets, and most of them have appeared in just the last five years. ETNs are often confused with exchange-traded funds (ETFs) because both of them can be traded throughout the day. It is there, however, that the similarity ends. Unlike ETFs, which normally hold the underlying constituents of the index, ETNs hold nothing except the promise of the issuer to deliver the return of the index minus fees. If the issuer were to become insolvent, then the ETN holders would be SOL (sadly out of luck). Investors in the ETNs issued by Lehman Brothers lived in this house of pain in 2008.

In an article published last year, “IFA’s Concerns with ETFs,” Index Funds Advisors, Inc. warned investors away from ETNs along with leveraged/inverse and commodity-linked ETFs. Our reasoning was simply based on the idea that investors are better served by holding the underlying assets of an index rather than relying on somebody’s promise to pay them the returns of the index. Furthermore, some of the “indexes” tracked by ETNs are based entirely on currency movements or changes in stock market volatility, and thus not appropriate for most retail investors. As it turns out, even if the ETN issuer makes good on its obligation, investors could still get a very different return from what they were expecting due to a sudden change in spread between the share price and the net asset value of the ETN. A drastic example of this phenomenon occurred with two ETNs issued by Credit Suisse Group AG and Barclays PLC. The Credit Suisse ETN (VelocityShares Daily 2x VIX, TVIX) dropped by 50% from March 21st to March 23rd while the underlying index of S&P 500 Volatility (VIX) only dropped by 2%. Talk about tracking error!

The Barclays ETN (iPath Natural Gas Total Return, GAZ) dropped by 29% from March 6th to March 13th while the price of natural gas only dropped by 7%. In fairness to Barclays, the commodity-linked ETF that is supposed to track the price of natural gas (United States Natural Gas, UNG) has also done a very poor job of it, but for an entirely different reason. Further details on the shellacking received by investors with both UNG and USO (United States Oil) may be found in “Commodity ETFs Revisited.”

Regarding exchange-traded products, IFA’s advice to investors remains unchanged. ETFs are best used to achieve long-term exposures to sensibly constructed indexes as part of a globally diversified portfolio of index funds. IFA advises investors to avoid the temptation to trade ETFs, even if no commissions are charged. IFA also cautions investors away from commodity-linked ETFs, leveraged/inverse ETFs, extremely specialized ETFs, active ETFs, and exchange-traded notes.