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Defining ETNs And Your Profit Opportunities With Them

When most investors hear the term exchange traded products, they probably think ETFs and that's probably because ETFs do dominate the exchange traded products business. Last month, when exchange traded products listed in the U.S. eclipsed the lofty $1 trillion assets under management level, the almost 900 ETFs held about $887 billion of those assets.

So where was the difference made up? Primarily with ETNs, or exchange traded notes. Other exchange traded products accounted for 185 funds and $115.5 billion in assets, according to the Wall Street Journal. So what the heck is an ETN and do they have a place in your portfolio?

To start, investors must note that there are differences between ETFs and ETNs and knowing these differences is crucial to making informed investment decisions. When I talk with subscribers that ask about ETNs, I define these instruments in the simplest terms I know possible: ETNs are unsecured, unsubordinated debt obligations, but they're different from bonds because they don't pay interest. The returns of ETNs are based on the indexes they track.

In other words, an ETN attempts to give investors elements of bond and ETF investing. Sounds pretty good, but there is a cautionary tale with ETNs. These are debt obligations and if the bank issuing your ETN goes bankrupt, then you become a creditor, just like any other bondholder. This a problem that wreaked havoc on the ETN business during the financial crisis when banks like Bear Stearns and Lehman Brothers were failing.

On that note, the good news is most of the firms that issue ETNs are big enough players that their home governments won't let them go bankrupt, so the credit risks involved with ETNs have diminished dramatically over the past couple of years.

With that out of the way, there are several advantages worth noting with ETNs. First, they cover a wide swath of asset classes. Bonds, domestic equities, emerging markets and commodities can all be accessed via ETNs.

In terms of ETNs that can be viewed as plays on equities, an investor could have captured some very nice performances in 2010 by opting for ETNs tracking India or master limited partnerships (MLPs).

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Of course, one of the best ways to access commodities is with ETNs. Moving beyond gold and oil, there are plenty of other commodities out there can be profitable trades. Think coffee, cotton, cocoa and livestock. Prior to the advent of ETNs, retail investors had slim pickings for getting involved with these commodities. Thanks to ETNs, you don't need to miss out on what is expected to be a very bullish 2011 for the likes of cotton, livestock and agriculture futures.

There is also a tax advantage to owning an ETN or two in that they do not distribute income. ETFs and mutual funds can expose investors to distributions and short-term capital gains, but with ETNs, the only tax you'll pay is on your profits at the time of sale.

In an environment of diminishing credit risk for issuers and soaring commodities, 2011 is shaping up to be an excellent year for ETNs. If you're still on the ETN sidelines, get in the game soon.

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Remember, although ETFs combine the best of both worlds of stocks and mutual funds – they can act totally different from each in real life.

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