Exchange-Traded Funds (ETFs) have taken the investment world by storm. First introduced in 1993, by the end of 2012 ETFs had attracted some $1.3 trillion in assets. As a follow-up, investment banks have launched a slew of other exchange-traded products (ETPs) that are substantially more risky that the standard ETFs, but whose downside is seldom made clear to retail investors.

One big source of potential confusion is ETNs (Exchange-Traded Notes). Introduced in 2008, these vehicles have already amassed some $500 billion in assets. But they are a far cry from ETFs. 

Below, we take a closer look at ETFs and ETNs, so you know what you’re getting into.

ETFs: Mostly Index Investing

Most Exchange-Traded Funds (ETFs) replicate a specific bond or stock index, and they trade on a stock exchange. The issuing companies rely on “authorized participants” to manage the inflow and outflow of investment, in large blocks called “creation units.” ETFs are popular because of their low fees, liquidity, transparency, and access to specialized indexes.

ETFs can have different structures, affecting how they’re traded and taxed.

Unit Investment Trusts (UITs). The oldest and largest ETFs were set up as “Unit Investment Trusts.” UIT ETFs are required to fully replicate their underlying index, and may not “lend” out their shares to short sellers (to collect a fee in return). They also don’t reinvest dividends; they’re paid out to shareholders.

Examples of UIT ETFs include: SPDR S&P 500 (NYSE: SPY), the very first and still largest ETF, introduced by State Street in 1993, now with some $123 billion in assets; and Invesco Power Shares QQQ  (NASDAQ: QQQ), which tracks the NASDAQ 100 and has $32 billion in assets.   

Open Investment Trusts. Most ETFs are open investment trusts. They don’t have to exactly replicate their index, as long as they track it very closely. They reinvest their dividends. And they can “lend” out shares they own to hedge funds or short sellers to collect a fee.

Examples here include: Vanguard Emerging Markets ETF (NYSE: VWO), the third-largest ETF, with $61 billion in assets; Vanguard Total Stock Market ETF (NYSE:VTI), which tracks the entire US stock market; iShares iBoxx Investment Grade Corporate Bond Fund (NYSE: LQD), the largest bond ETF; and Barclays TIPS Bond Fund (NYSE:TIP), which tracks the Barclay’s US TIPS Index, based on all US Treasury inflation-protected securities with at least one year to maturity and at least $250 million in face value.

Commodity ETFs.  It’s worth noting that the second-largest ETF is now SPDR Gold Trust (NYSE: GLD), with $70 billion in assets. This ETF actually invests in gold bullion, and its shares represent claims on that bullion, held in London vaults in the custody of HSBC Bank USA. Each share of GLD represents about one 10th of an ounce of bullion at current market prices.

GLD and other ETFs that actually hold gold, silver and other commodities are usually set up as grantor trusts and taxed at the same rate as collectibles: 28 percent on long-term gains. Less-than-a-year gains are taxed as ordinary income.

Grantor Trusts that use futures contracts are in a separate category. An example is PowerShares DB Commodity Index Tracking Fund (NYSEARCA: DBC). Taxes are due annually, based on a blended rate: 60 percent of gains are taxed at the long-term rate of 15 to 20 percent, and 40 percent of the gains are taxed at your ordinary income rate.  At year-end, investors are sent a Schedule K-1, instead of the more familiar 1099.

To avoid higher taxes, many investors put Grantor Trust ETFs in tax-advantaged accounts, such as IRAs.

ETNs: A Different Animal

Exchange-Traded Notes (ETNs) are derivatives, since they do not give you an equity interest in anything. Like most ETFs, they track an index (often a commodity futures index). But unlike ETFs, they do not invest on your behalf in the assets that comprise that index.

Structurally, ETNs are debt securities with no collateral, and are not regulated by the Investment Company Act of 1940. As a result, ETNs could suffer losses should the sponsor go bankrupt.

This is cause for concern. Lehman Brothers and Bear Stearns had both issued ETNs when they went bankrupt in 2008.  The Bear Stearns clients were rescued when those ETNs were transferred to JP Morgan Chase. But holders of the Lehman ETNs are unlikely to recover any where near their investment.

Other problematic aspects of ETNS include: ETNs are thinly traded and often have larger bid-ask spreads than ETFs; the fees on ETNs can be much higher than you think, and are often based on a scale that escalates over time; the pricing of the futures indexes many of the ETNs are based on is not easily accessible to the lay investor; ETNs in general have terrible long-term returns.

For the above reasons, ETNs should be used as trading vehicles by well-informed investors who have read the fine print in the prospectus.  

Below is a closer look at two popular ETNs:

iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE: DJP).  This tracks the Dow Jones-UBS Commodity Index Total Return Index, comprised of futures contracts that are about 30 percent oil and natural gas, 11 percent gold, 10 percent soybeans, 7 percent corn. It’s not clear why you’d want to bet on all these very different commodities at once. The five-year return on the ETF is an annualized loss of more than 7 percent.

iPath S&P 500 VIX Short-Term Futures ETN Profile (NYSE: VXX). This tracks the S&P 500 VIX Short-Term Futures Index Total Return and is Exhibit A on why investors should not buy and hold ETNs. VXX’s loss from its March 2009 peak is nearly total—close to 100 percent.

The danger is not just long-term. The loss for 2012: 78 percent. However, this ETN’s trading volume has risen over the years, so certain savvy traders are finding this a useful vehicle (see graph below).

Niche Players

Be especially wary of leveraged ETNs, which borrow to potentially double your gains…and losses. For example: PowerShares DB Gold Double Long Exchange Traded Note (NYSE: DGP). This is a “double long leveraged” ETN tracking the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold (200%).

From October 2008 to the peak for gold in August 2011, DGP gained nearly 500 percent vs. 160 percent for gold. But since then, DGP is down 30 percent vs. 13 percent for gold itself.

JPMorgan Alerian MLP Index ETN (NYSE: AMJ).  One of the largest ETNs, with about $5.5 billion in assets, AMJ follows the performance of Master Limited Partnerships (MLPs) in the energy sector, primarily in the energy infrastructure area, such as pipelines. Over the past 3.5 years AMJ has nearly doubled in price and it recently yielded more than 5 percent.

However, there are serious tax consequences with AMJ. With MLP ETNs, investors are treated as owning a debt instrument. So the income is taxed as ordinary income rather than qualified dividends or partnership distributions.

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John Lounsbury is managing editor and co-founder of Econintersect LLC, publisher of Global Economic Intersection.