Exchange-Traded Notes: 'Death Calls' Are Premature

When Barclays (BCS) first rolled out the exchange-trade note (ETN) concept with the iPath brand, I was definitely intrigued. In fact, one of my favorite investments for years was the Dow Jones Total Commodity Index (DJP).

The concept was simple enough. The ETN backer issues contractual notes that perfectly mimic the value of the benchmark. If that index rose 15%, investors would receive the exact amount of the index minus the ETN provider's expenses.

In this manner, you didn't have to worry about ETF tracking error, let alone premiums or discounts to net asset value. You also didn't have to fear any capital gains distributions since an ETN doesn't actually hold the stocks, commodities or currencies.

Then, an unfortunate reality came to fruition. Since ETNs are essentially the equivalent of a relationship between a financial provider and a purchaser, ETNs have "credit risk." So when the global credit crisis threatened the well-being of mammoth corporations like Barclays... when major financial institutions seemed to be going the way of the dinosaurs... ETNs nearly became extinct.

Well... the "death call" may have been premature.

Stan Luxenburg writing for the Street.com points out that currencies, commodities and some emerging market stocks are hard to trade, giving some ETFs "fits" at replicating indexes. One has to look no further than the well-publicized problems that United States Oil (USO) has had at approximating the price of crude.

Still, is it true that ETNs are really better at tracking difficult-to-approximate indexes? Luxenburg compared the calendar year performance of the ETF PowerShares India Portfolio (PIN) with the iPath MSCI India Index ETN (INP). INP has achieved 65% (through 7/28/09) whereas PIN returned 55%.

To be fair, Luxenburg is being a bit disingenuous here. Not only are the investments tracking different indexes (Powershares is tracking the Indus Index, not MSCI India), but the WisdomTree India Earnings Fund ETF (EPI) garnered 64% while tracking yet another index.

If the exchange-traded note is clearly superior, shouldn't we be looking at the same index and a longer time frame than 7 months? Even though a 1-year period is insufficient, it's enough to show that INP did not perform as well as EPI or PIN in that time frame.

I'm not writing to dispute the potential benefits of ETNs. Moreover, Luxenburg is careful to explain that if Barclays defaults, its iPath notes could be worthless. Yet let's not be so quick to declare one vehicle better than another.

In commodities, there's my old favorite in the iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP). Yet when I used stop-losses to keep gains after the commodity bubble burst, I did not go back so quickly to DJP. With the reflation of the global industrial cycle, PowerShares DB Commodity Index Tracking Fund (DBC) is serving my purpose.

True, DJP is better diversified across 10 commodities, whereas DBC may have as much as 50% exposure to crude and heating oil. Moreover, DBC deals with futures, which does not always end up representing underlying indexes. Yet at this point, there's little reason to fret the total commodity exposure that I am achieving.

The performance speaks for itself. DBC has outperformed DJP over 3 years by 1500 basis points. And on a calendar year basis, the results are identical.

Full Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. The company may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

Comments

[Bob Mayo]

Thanks for the excellent article. Don't forget that DJP tracks a futures index (composed of 19 different futures contracts), not the spot prices.

2009 Jul 30 10:38 AM

[Mary Hunt]

The original headline of this article was 'Why the ETN Death Call Was Premature.' To avoid any confusion with Eaton Corp., ticker ETN, we have changed it at the author's request.

2009 Jul 31 03:50 PM