An elite investment that cuts taxes

Another advantage

Seen as investments rather than tax shelters, ETNs have one other very big plus: zero tracking error. Conventional index funds do their best to replicate the performance of a benchmark, typically by owning a number of the constituent securities, but they don't always succeed.

Last year, iShares MSCI Emerging Markets Index ETF (EEM, news, msgs) advanced 34.6%, 4.8 percentage points less than the benchmark index itself. Vanguard Emerging Markets ETF (VWO, news, msgs), which tracks the same index, missed it by 1.3 points, far more than its own 0.25% expense ratio.

ETNs pay exactly what the index delivers, minus their own expenses, which typically are 0.85%. Issuers accept the risk that if they fail to earn enough to repay investors, they have to make up the difference out of their own pockets.

Dabbling in debt

But they also have one very big minus: They are unsecured debt of the issuer, and, as such, shareholders have virtually no protection if issuers default. Out of the question? The issuer of the new BearLinx ETN is Bear Stearns (BSC, news, msgs), which over the weekend agreed to be acquired by JPMorgan Chase (JPM, news, msgs) for $2 a share. One year ago, Bear's shares were trading hands at $170.

Mutual funds can default as well, but it happens rarely, and when it does, they still have at least some assets. I owned a pair of high-yield municipal-bond mutual funds some years ago that collapsed and left me, as I recall, 13 cents on the dollar. But at least my interest in those bonds was secured. Had it been unsecured, I would have gotten nothing.

You can examine the universe of ETNs at the MSN Money ETF Performance Tracker. (Use "Control F" on your keyboard to search for "ETN." )

But before you buy, also search for ETFs that target the same goal. From many points of view, ETFs and ETNs are interchangeable. For example, Deutsche Bank, issuer of the leveraged gold ETN, also offers ETNs that are short, DB Gold Short ETN (DGZ, news, msgs), and leveraged short, DB Gold Double Short (DZZ, news, msgs). But it doesn't offer an unleveraged long ETN. That's because it already has an ETF in that space: PowerShares DB Gold Fund (DGL, news, msgs).

Compare ETNs against ETFs carefully, remembering that the latter are more heavily regulated and thus, at least in principle, more shareholder-friendly.

But if the advantages, such as tax savings, outweigh the disadvantages, particularly the vulnerability of default, ETNs can be useful portfolio additions. Assuming those advantages survive the political process.

At the time of publication, Tim Middleton owned the following securities mentioned in this article: PowerShares DB Agriculture.

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