Your Money: Cousins ETNs and ETFs trade differently

ETNs and ETFs make for confusing abbreviations, but it's important for investors to understand the difference. Exchange-traded notes and exchange-traded funds are often lumped together because they both track the performance of an index, a commodity, or a sector, and they both trade like a stock.

But ETNs (the notes), unlike ETFs (the funds), are not portfolios of investments. Instead, they are contracts in which the issuers, often big banks or mutual fund companies, agree to pay investors returns that are equal to the investments they aim to track. But it turns out that the notes don't always track the underlying investments very well.

Exchange-traded notes "can carry a raft of risks," Gerri Walsh, regulator FINRA's vice president for investor education, said in an investor alert issued last week, titled "Exchange-Traded Notes — Avoid Unpleasant Surprises." She warns potential buyers that the securities entail credit risk and may have inherent conflicts of interest. In other words, the notes' performance can be at the mercy of the issuer and the investor may have fewer rights than with a stock or bond.

Notes may also be illiquid, subject to early redemption at the issuer's discretion, and they may trade at a higher — or lower — price than their underlying index.

Case in point: Credit Suisse earlier this year stopped issuing shares of an ETN that was tied to the Chicago Board Options Exchange Volatility Index. Used to bet on the volatility of the markets, the note began diverging from its underlying index to trade at a premium of as much as 89 percent. Then over two days in March, the note lost more than half of its value.

"If the ETN is trading at a significant premium to its closing value, investors might want to consider similar products that are not trading at a premium," FINRA said in the alert. Notes can often use leverage or borrowed money — so if you use one to make a wager and double or triple up your bet, that's wonderful if it makes money. It's horrible if it loses money, and it can force a margin call on your account.

Because of their structure, notes are actually unsecured bank debt backed by their issuer's credit. The funds, on the other hand, hold assets, as in a mutual fund. Banks create and redeem units of notes and funds based on the level of demand for the securities. For a full description of the dangers and what to know before you invest, check out FINRA's release at http://bit.ly/NeeqEq.

Exchange-traded funds have their quirks, as well. Bond giant PIMCO has an ETF version of its mutual fund that's actually doing better than the much larger underlying fund.

The Pacific Investment Management Co.'s $263 billion PIMCO Total Return Fund has been performing well and attracting huge amounts of money. It is actually returning less than the firm's brand new exchange-traded fund tracking the same basket of assets. The ETF, however, is more than 100 times smaller. While the world's largest mutual fund has returned 3.2 percent since March 1, the PIMCO Total Return ETF (BOND) that started Feb. 29 with a similar mandate has gained 6.8 percent, according to Bloomberg data.

Retail investors have another option to use when picking stocks: technical analytic software created by a local Philadelphia investor, Marc Chaikin of Chaikin Investment Research. "The biggest problem in managing your portfolio in such a volatile climate is earnings season. There are potential land mines everywhere," according to Chaikin, who says his Power Gauge rating guides you through the minefield.

His new Chaikin Portfolio Health Check is a subscription service that looks at your portfolio and singles out bullish or bearish indicators. For instance, he says, his research showed that Alcoa expected good earnings but also had a bearish rating; that is, it is unlikely to trade well, based on its international exposure.

His research also identified the same trend in such companies as Procter & Gamble and Caterpillar, which boast heavy revenues outside the United States.

"Companies like TJMaxx, Comcast and CVS with primarily domestic revenues, have done better. Our ratings have zeroed in on this trend," he said. He recommends that clients swap out of Caterpillar and into John Deere, and that investors in Nike, with heavy China and Europe exposure, swap into Skechers.

Lest this sound like an advertisement, Chaikin's tools have been backtested for performance (according to his website at http://bit.ly/P90QFQ). Did they make money? The research for 2011 doesn't seem to do as well on bullish picks; the bearish picks, however, were down 19 percent in 2011.