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The Troubling Evolution of Exchange-Traded Products

It’s sad when such a sweet, simple concept can become so bastardized.

On January 29, 1993, State Street Global Advisors put forth a product that offered the diversity of a full portfolio, the agility of a stock and a cost that would make a mutual fund manager blush. That product? The Standard & Poor’s Depositary Receipts known to you and I as the SPDR S&P 500 ETF (NYSE:SPY ), the first U.S. exchange-traded fund.

Twenty years later, we find ourselves in somewhat of a perception pickle. The SPY marked the beginning of the exchange-traded product industry a market now with thousands of products and more than $1 trillion under management. ETFs are a frightening and very real threat to mutual funds according to the Investment Company Institute (via Bloomberg ), “U.S. investors added $4.82 to exchange-traded products last year for every $1 they deposited with mutual funds.”

But along with this breakneck growth has come deformity, exemplified by the industry’s very own name: “Exchange-traded product.” It’s a necessary term bred from the mutated evolution of exchange-traded funds into items like exchange-traded notes debt securities all gussied up like funds that track indices like funds do but aren’t really funds. Exchange-traded products have become trader playthings that tempt investors with offerings of double and triple “returns” or the ability to play “fear.”

The Reformed Broker ’s Josh Brown sums up this path to growth in ETPs in his usual insightful, punchy way :

“Innovation is great, but we have to accept the fact that there will be failed and even dangerous innovations along the way. In my view, we are at the stage now where many dangerous notions are being productized so it is up to the individual to not do stupid things with new vehicles they dont truly understand.”

He couldn’t be more right. So, it’s up to individual investors (read: not day traders) to do two things:

1. Arm yourself with knowledge.
2. Don’t put your money where your brain isn’t.

While I can’t offer to stay your hand as you guide your mouse toward “buy,” I can at least help with the first task. Here’s a few “dangerous innovations” and other exchange-traded products you should approach with caution or not even approach at all:

Double Dividend Funds

These products come first solely because they’re fresh on the mind. I recently discussed these funds the ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (NYSE:DVYL ) and ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (NYSE:SDYL ) and their dangers, but the gist is this: These exchange-traded notes are just like any other ETNs in that their performance is tethered to an index, sure, but they’re debt securities to the core.

What does that mean? Well, it means products have the potential to perform in ways that have little to do with the index they track, like the VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX ) did in March. Issuer Credit Suisse (NYSE:CS ) basically stopped production of units in February, causing a bubble in demand, then said in March it would begin reissuing them again causing the TVIX to tank in the face of new supply, knocking 50% off the ETNs price. That drop had nothing to do with the underlying index.

And thus, it means that you’re not necessarily getting double the returns from the equities that ETNs track, nor are you getting double the dividends they release you’re getting the commensurate amount from UBS (NYSE:UBS ). So, just hope nothing happens to UBS.

The reason the ETRACS products get a special nod here is because of their moniker. Investors have been rushing into income stocks and funds in recent months, so needless to say, the attraction of a product that combines “2x” with “dividend” is a recipe for investor calamity. Yes, buyer beware, but we don’t live in a perfect world, and many people unfortunately invest in what they don’t know.

Now you know.

Other Reassuringly Named ETNs

Along with the “double dividend” funds, here are a few other ETNs that might accidentally give you the warm ‘n’ fuzzies:

• Commodity ETNs, such as the the iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE:DJP ), MLCX Grains ETN (NYSE:GRU ) or iPath Dow Jones-UBS Copper ETN (NYSE:JJC )
• Emerging-market ETNs, such as the iPath Long Enhanced MSCI Emerging Markets Index ETN (NYSE:EMLB ) or iPath MSCI India Index ETN (NYSE:INP )
• Bond ETNs like the PowerShares DB 3x Long 25+ Year Treasury Bond ETN (NYSE:LBND ).

And in cases like the emerging-market and bond ETNs, several legitimate ETF options are available.