Do ETNs Belong in Your Portfolio?

Includes: DBA, JJA, RJA
by: Hard Assets Investor

Hard Assets Investor Editor's Note: The recent growth of the exchange-traded note market has caught many market-watchers by surprise. Every day, it seems, a new batch of commodity-focused ETNs are launched onto the market. Last week, Deutsche Bank even launched ETNs that provide 200% and -200% of the monthly return of its broad-based DBC commodity index. It offers similar products tied to gold.

What are ETNs? In many ways, they are similar to ETFs: They track the performance of an index or an individual asset (like currencies), they trade like stocks and they charge investors fixed expenses. But there is one important difference: ETNs are actually debt notes. The issuing bank promises to pay investors an amount equal to the value of the target index. If the underwriting bank goes bankrupt, investors still holding the ETN in their brokerage accounts could be left holding the bag.

With the continued growth of the ETN market, we asked HAI contributor Roger Nusbaum what he thought about the new products, and whether he would use them in his portfolio.

His answer follows below.

I was asked for my opinion on exchange-traded notes [ETNs], the debt-based cousins of ETFs. The big macro view is that ET-whatevers simply provide investment exposure to something; maybe a country, a sector, a commodity, a currency, and maybe in the future, more interesting things like the Baltic Dry Index or a basket of GDPs from several emerging market countries. (Anyone? Anyone?)

That the exposure is captured via a stock or ETF or ETN or something else is not the first priority. The first priority should be seeking out what you think is the best exposure.

In trying to invest in, for example, agriculture/soft commodities, there are a few different products, mostly ETNs.

The most popular ETF in the space, PowerShares DB Agriculture Fund (AMEX: DBA), has positives that include: the fund actually owning contracts for the underlying; the fact that the Treasuries collateralize the contracts and the fund pays out this interest income on a regular basis; and, at times, the fact that the underlying index only covers four commodities (soybeans, sugar, corn and wheat), which can provide a performance advantage if those commodities are doing well.

The negatives include that, at times, only having four commodities means less diversification, and so maybe more risk. In addition, you may have heard that DBA has run into position-limit issues and has had to come up with an alternative plan for managing to the objective.

The two ETNs in this same space that I am most familiar with-Rogers International Commodity Index Agriculture Total Return (NYSEARCA:RJA) and iPath DJ AIG Agriculture Total Return Sub-Index (NYSEARCA:JJA) - are more diversified, which is a positive. They do not pay out interest income from collateral Treasuries investments; instead, that income is incorporated into the value of the note and only realized by shareholders once the note is sold.

Forgetting the wrapper [ETF vs. ETN vs. mutual fund] for a moment, if you wanted agriculture commodity exposure, would you prefer broader or narrower exposure? To me that is far more important than the wrapper. So let's say that you do want broader exposure, and so it will either be RJA or JJA. Now the wrapper becomes a little more important. A study followed by an understanding will lead you to your conclusion as to which one is right for you.

ETNs own nothing; they are a debt obligation of the bank that issues them along with a promise that the ETN will track the thing it is supposed to track. Generally I would say that RJA and JJA have tracked their respective indexes, but you should check this out for yourself and decide for yourself. Someone looking for an exact match-save for the fee-might not be too happy, but someone more concerned with generally capturing the effect of agricultural commodities and diversifying their equity exposure probably would be.

Given all of the issues in the financial sector and the potential impact on some of the banks issuing ETNs, it makes sense to think about issuer risk. The current event is meaningful enough to expect a big financial company to fail; maybe Bear Stearns was it, or maybe there will be a bigger one. While one or two big failures is a reasonable expectation, a dozen big failures is not. The odds of any one bank failing are slim, but it is possible. To that point I would suggest not putting too many eggs in any one bank's basket.

An allocation of commodities of, say, 8% spread across a PowerShares ETF, streetTRACKS Gold (NYSEARCA:GLD), an Elements ETN and an iPath ETN (this is just a generic example) would mitigate the risk on any single portfolio of a failure. It is a very good bet that Barclays will not fail, but if it does go down, the impact of a 2% wipeout versus all 8% is significant.


Disclosure: GLD and DBA are client or personal holdings.