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), an ETF, and iPath MSCI India Index ETN ( INP). 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.
During the first six months of 2009, iPath India ETN returned 54.7%, while PowerShares India ETF returned 46.7%, according to Morningstar. Can the ETN lead over the long term? That's hard to know. But the ETN clearly has an advantage for investors in taxable accounts. Make no mistake, ETNs come with special risks. The iPath ETN is backed by Barclays, which sold its ETF business to BlackRock ( BLK). (ETNs weren't part of the deal.) So if the bank defaults, the notes could be worthless. Investors learned about this risk last fall when Lehman Brothers went under and defaulted on $15 million worth of exchange traded notes. Seeing Lehman's collapse, investors dumped ETNs of all kinds. But these days, major ETN issuers -- including Barclays, Deutsche Bank ( DB) and HSBC ( HBC) -- seem to be in sound shape. Confident about the outlook, money is flowing back into ETNs, which now hold $5.8 billion in assets. A year ago, the tax advantages of ETNs came under assault. Mutual fund companies urged Congress and the IRS to change the tax status of ETNs. But the IRS has made no pronouncements on the issue. Now that Washington faces a welter of economic problems, it seems unlikely that the IRS will have the time or inclination to focus on ETNs. For investors seeking exposure to commodities, ETNs offer access to attractive benchmarks. A solid choice is iPath Dow Jones-AIG Commodity Index Total Return ETN ( DJP). This tracks a broad collection of 10 assets, including oil, copper, aluminum and soybeans. As an alternative, you could try an ETF, PowerShares DB Commodity Index Tracking Fund ( DBC), which invests in five assets, including oil, gold and corn.
Either choice can provide exposure, but the ETN is more appealing because it offers greater diversification, says Bradley Kay, a Morningstar analyst. While the ETF has half its assets in crude and heating oil, the ETN only has 22% of its weight in energy. The diversification is important because a big part of the gains in a commodity portfolio can come from rebalancing asset classes, Kay says. For example, the ETN has about 4% of its assets in wheat. If grain prices skyrocket, wheat could exceed its target weight. Then the benchmark would have to rebalance, shedding high-priced wheat and shifting assets to categories that are lagging. This process of selling expensive assets and buying cheap ones typically produces long-term profits. For a different way to diversify commodity holdings, consider Elements ETN S&P Commodity Trends Indicator ( LSC), which invests in 16 assets, including coffee, natural gas and silver. The ETN has the distinction of having made money in the fourth quarter of 2008, when stocks and commodities crashed. The S&P Trends index stayed in the black because it tracks a mix of long and short positions. The blowup in commodities signaled the ETN to go short, enabling investors to profit when nearly every mutual fund and ETF was sinking into the red.