Morningstar Advisor - June/July 2012 - (Page 61)

Gray Matters Dangers Lurk in ExchangeTraded Notes By Samuel Lee Investors who buy ETNs enter into an uneven relationship with more sophisticated counterparties who are very willing to take advantage. The decision to invest in an exchange-traded note seems to depend on a straightforward calculus, the trade-off between credit risk and the ETN’s tracking and tax benefits. Unlike an exchange-traded fund, an ETN is essentially an uncollateralized loan given by an investor to an investment bank, with all the risks that entails. In return, the bank promises exposure to an index’s return, minus fees, regardless of how hard it is to actually own the index’s underlying assets. On top of that, many (but not all) ETNs are taxed like stocks, thanks to a quirk in U.S. tax law. These benefits could be a godsend for investors who want entry into less-liquid, tax-unfriendly strategies. As long as investors keep their eyes on credit risk, they can have their cake and eat it, too. At least, that’s the conventional wisdom. It’s wrong. ETNs are so much more dangerous than that. They are one of the easiest ways individual investors and advisors unwittingly enter into adversarial relationships with vastly more-sophisticated investment banks. Unlike mutual funds and most ETFs, ETNs are not registered under the Investment Company 61

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2012

Morningstar Advisor - June/July 2012
Letter From the Editor
Be Worth Remarking About
How Important Is Stewardship?
From West Point to Points East
Where a Fund’s Secrets Lie
Getting Fund Directors on Board
Managers Prep for Housing Rebound
Four Picks for the Present
Investment Briefs
A Hedge Against Career Risk
Natural Gas Reaches Capitulation
Family Matters
How Good Stewardship Predicts Superior Performance
Stewardship Goes Back to the Fundamentals
On the Go for Fixed Income
Where Shareholders Ride First Class
Dangers Lurk in Exchange-Traded Notes
Stocks on Sale in a Strong Market
A Good Steward Is Easy to Find
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
Buffett Rule’s Biggest Losers

Morningstar Advisor - June/July 2012