Exchange-Traded Notes Can Be Better Than ETFs

Move over, exchange-traded funds.

ETFs, which are portfolios of securities, have taken the investment world by storm in recent years. Investors like the fact that they always know they're holding and can trade them throughout the day -- two big advantages over mutual funds. Last month, the number of ETFs available in the U.S. reached 570, nearly 60% more than at the end of last year.

But there's a new kind of investment product that has less tracking error than an ETF and is more tax-efficient.

Like ETFs, exchange-traded notes track a benchmark index and trade on an exchange. But that's where the similarities end. ETNs don't hold stocks, bonds or even futures contracts; they are senior, unsecured debt.

That means investors might not get paid if issuer goes belly up, althougth the two investment banks that offer ETNs to date -- Barclays Bank, a unit of Barclays PLC(BCS Quote), and Bear Stearns(BSC Quote) -- are generally considered good credit risks.

This debt isn't a bond, however. When you purchase a bond you expect to get your principal back -- unless the issuer defaults. But if the index the ETN tracks declines in value, so does your investment.

On the plus side, ETNs avoid two potential pitfalls of ETFs. Investors don't have to worry that an ETN's returns will move out of line with its benchmark index. Tracking error can be a problem for some ETFs, particularly if they can't hold all of the securities in their benchmark because there are too many or the constituents are too illiquid. In these cases, the sponsors may use futures, swaps or other instruments to approximate an index's return, sometime unsuccessfully.