ETF Explosion Overshadows Benefits of ETNs

NEW YORK (TheStreet) -- Hoping to profit from rising prices for oil and emerging-markets stocks, investors have been buying exchange traded funds (ETFs) lately. But instead of betting on ETFs, you may prefer exchange traded notes (ETN).

The notes suffered when credit markets froze last fall, and some analysts warned that ETNs were about to disappear altogether. Now, the instruments are back on firm footing, offering efficient vehicles for investing in commodities, emerging market stocks, currencies and other assets that are difficult to trade.

There are 86 ETNs listed on the New York Stock Exchange. Like exchange traded funds, ETNs trade constantly and can be sold short. But ETNs can be more tax efficient and track benchmarks more closely than ETFs do. To appreciate the appeal of the notes, compare PowerShares India Portfolio(PIN Quote), an ETF, and iPath MSCI India Index ETN(INP Quote).

To track the Indian market, the ETF actually buys and hold shares of 50 of the biggest stocks. When it makes purchases, the fund must pay brokerage commissions and absorb other transaction costs. Buying stocks in India can be particularly expensive because some of the stocks are small and hard to trade. In addition, owning the stocks can generate tax bills. Under Internal Revenue Service rules, the ETF must distribute dividends to investors, who owe taxes on the income.

In contrast, the ETN doesn't own any stocks outright. Instead, the ETN backer issues notes that track the value of the benchmark. If the index rises 10%, investors get exactly that amount minus expenses. Because the ETN holds no stocks, investors receive no income and need not pay any taxes unless they sell the notes at a profit.