Smart Exchange-Traded, Product-Investing Basics

By Stepleman, Dr Robert | Sarasota Herald Tribune, November 19, 2012 | Go to article overview

Smart Exchange-Traded, Product-Investing Basics


Stepleman, Dr Robert, Sarasota Herald Tribune


JUST AS IN EVEN A WELL-TENDED garden some weeds will always appear, over the last several years "weeds" have sprouted in the "garden" of exchange-traded products or "ETPs." Recall that in the garden of ETPs there are two main species - exchange-traded funds or "ETFs" and exchange-traded notes or "ETNs."

Along with pulling the weeds, let's review the basics of ETPs.

ETFs are usually unmanaged "baskets" of securities that mirror the performance of a broad market index, for example, the S&P 500. They are essentially an index mutual fund that looks and works like a stock.

These have the virtues of index mutual funds: broad diversification, low annual management fees and high tax efficiency, with the additional virtue that like a stock they can be bought and sold at any time.

ETNs are essentially bonds whose value and interest is based on the total return of some index composed of other bonds or stocks. Unlike investors in ETFs, investors in ETNs don't own a share of the underlying index. They only have a promise from the issuer to pay the interest and at some future date to redeem the ETN.

None of this means that investors should automatically rule out ETNs. It does mean that these are more complex securities than typical ETFs and require careful analysis before any decision is made.

One way to avoid ETN weeds is to understand that since they are essentially bonds, their price is partly determined by a credit rating; however, it is not a credit rating for the ETN itself but for its issuer; for example, Barclays Bank the issuer of the first ETN.

This means that investors take on credit risk. If the issuer is downgraded by a bond rating agency, the ETN may fall in value even if the prices and prospects of the securities in the underlying index do not change. Thus, investors in ETNs must decide if the return they may get from the ETN is enough to compensate for this additional risk.

Some ETNs are also relatively illiquid. This usually means that they have relatively low trading volume and their value may not closely track their underlying index. …

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