Investing on a Sour Note

Exchange Traded Notes (ETNs) rode the same wave of interest that drove investor interest in ETFs. But now, their paths are diverging. Touted as a close cousin of ETFs, several ETNs flourished, and most investors didn't really notice the difference between the two investment types.

Yet ETNs are missing some key attributes of their more popular mutual fund relatives. When Lehman Brothers filed for bankruptcy, the differences between these two products moved to the forefront and caused ETNs to lose a lot of their allure. The financial crisis has changed the playing field enough that investors should look hard at any ETN they hold or are considering as an investment.

Specialty products
The two most popular areas for ETNs are commodities and currencies. Investors enjoyed some sweet returns from notes like the iPath Dow Jones-AIG Sugar ETN (NYSE: SGG  ) in better times. Now, many have soured on these former hot investments, abandoning everything from livestock to food crops and precious metals.

Now that those sectors have fallen out of favor, attention has turned to some of the downsides of ETNs. Those who ignore the risks of ETNs could get a nasty surprise.

Riskier than ETFs
ETNs are debt instruments of the company that issues them. Therefore, investors don't have rights to a pool of assets as they do with an ETF. Since ETNs do not have assets, an investor only has a claim against the sponsor of the note. The recent bankruptcy of Lehman Brothers, sponsor of the Opta ETNs, highlighted the fact that it is critically important for an ETN investor to consider the credit quality of an ETN issuer before investing.

Investors in ETNs can reduce their risk by limiting their exposure to notes sponsored by the larger and more financially secure sponsors. For example, Barclays (NYSE: BCS  ) is the most prolific ETN sponsor, and it currently has a AA credit rating for long-term debt. According to the company, that rating has remained unchanged since 1994. MarketVectors ETN sponsor Morgan Stanley (NYSE: MS  ) , on the other hand, has a lower A+ rating.

Finding ETF substitutes
The initial rationale for investing in ETNs was to get exposure to asset classes that were not typically available to individual investors. In the case of currencies and energy, however, there are now enough ETF options to slake the thirst of most investors.

In the commodity arena, there are still some gaps in the ETF lineup. But those tend to be narrow, single-commodity niches. Investors can easily get broad based exposure by investing in a fund like the PowerShares DB Commodity Index Tracking Fund ETF (AMEX: DBC  ) , which tracks an index that includes crude oil, heating oil, gold, aluminum, corn, and wheat.

Not worth the risk
A note backed by a Swedish-government owned entity, the Elements ETN Rogers AgTR (NYSE: RJA  ) , would not have sounded like a risky investment a short time ago. But that was before Iceland became a financial basketcase and showed the world how far a nation can fall in the blink of an eye. Although the potential for default on this and other ETNs may be low, even the smallest chance of having to get in line with other debtors with unsecured claims will make many investors shy away from ETNs.

Shell-shocked investors worried about credit quality are running from any whiff of risk these days, and who can blame them? With uncertainty and fear rampant, investors may want to focus on those investment vehicles that have higher levels of regulation, security and fiduciary responsibility.

Since hitting the market roughly two years ago, ETNs have gone from the next new thing to a highly questionable product. In a more normal market environment ETNs made sense but now it seems downright foolish to invest in ETNs.

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Fool contributor Zoe Van Schyndel now lives in the Seattle area, where she enjoys the coffee and natural wonders. She does not own any of the funds or securities mentioned in this article. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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