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What Hidden Fees Are Buried in Your Fund’s Prospectus?

By Benjamin Shepherd on May 30, 2012

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Exchange-traded notes (ETN) are facing increasing criticism from both investors and analysts, as many of these products have failed to perform as investors had anticipated. One of the primary reasons for such discontent is that ETNs have murky fee structures that can rack up unexpected charges, leaving investors confused about why their ETNs failed to track their benchmarks. Of course, the irony is that ETNs are, at least theoretically, supposed to produce less tracking error than traditional exchange-traded funds (ETF).

Last week, UBS Global Asset Management launched two new ETRACS ETNs that offer unique dividend-capture strategies that investors will immediately find appealing. Unfortunately, the ETNs also utilize a fee structure that will generate additional revenue for UBS to the detriment of investors.

ETRACS Monthly Pay 2X Leveraged Dow Jones Select Dividend Index ETN (NYSE: DVYL) aims to double both the monthly return and income of the Dow Jones Select Dividend Index. This offering is an effort to capitalize on the success of the iShares Dow Jones Select Dividend Index Fund (NYSE: DVY), which is an unleveraged play on the same index. In order to be included in the index, stocks must pass screens for dividend-per-share growth, maintain payout ratios below 60 percent, meet minimum liquidity requirements, and have paid a dividend in each of the last five years.

ETRACS Monthly Pay 2X Leveraged S&P Dividend ETN (NYSE: SDYL) provides double the monthly results of the S&P High Yield Dividend Aristocrats Index, which tracks the 60 highest yielding stocks on the S&P 1500 that have also increased their dividends in each of the past 25 years. SPDR S&P Dividend (NYSE: SDY) offers unleveraged exposure to the same index.

ETRACS Monthly Pay 2X Leveraged S&P Dividend ETN should yield around 7 percent, while ETRACS Monthly Pay 2X Leveraged Dow Jones Select Dividend Index ETN should yield about 8 percent. These reported yields will likely attract hordes of income-hungry investors.

In reality, however, both notes use fee structures that will likely result in substantially lower payouts that their yields would otherwise suggest. While the S&P note lists an annual expense ratio of 0.30 percent and the Dow Jones note lists a 0.35 percent annual expense ratio–making them appear relatively inexpensive–both charge a sliding finance fee that will rise along with the index. So if the index performs well, UBS will collect higher finance fees. Most investors likely won’t be aware that such a financing charge exists unless they dig into each ETN’s prospectus, because it’s not explained anywhere else. Even then, they might not fully understand what they’re reading unless they’re attorneys or accountants.

The finance fee will be deducted from the income streams produced by the notes, reducing potential yields as well as overall performance. With the notes making monthly distributions, tracking error will quickly become evident, and it will be exacerbated by each note’s monthly reset of its leverage features.

Taxes are another potential pitfall. Whereas dividends paid by unleveraged funds are typically treated as qualified dividends for tax purposes–a much more favorable tax rate in most cases–distributions from these ETNs will be treated as ordinary income for tax purposes. That’s because ETNs are essentially structured as debt agreements, which means the Internal Revenue Service treats the income as if it were produced by bonds instead of stocks.

So while the ETNs’ high yields will likely entice investors, there’s a real danger that they may not fully understand that a high yield may not translate into a high payout.

What’s New

Socially responsible investing (SRI) strategies have been slow to gain traction among ETF investors, with the four existing SRI exchange-traded products holding just $357.3 million in assets. Nevertheless, AdvisorShares thinks it’s improved upon the typical SRI fund with its new AdvisorShares Global Echo ETF (NYSE: GIVE), which launched last week. The ETF employs a broad asset allocation strategy, which includes stocks, bonds and alternative investment strategies.

The fund is actively managed by four subadvisors. Two advisors focus on the equity allocation, with one handling a broad global equity sleeve, while the other oversees a more US-focused global equity sleeve. A third advisor runs the fixed-income sleeve, while a fourth advisor manages alternative strategies and asset allocation decisions.

The ETF’s managers favor companies that are proactive on sustainability issues and make a positive societal impact. The fund’s annual expense ratio is 1.70 percent–a hefty price in the ETF world–but about a quarter of the fees collected will be donated to the fund’s namesake, the Global Echo Foundation. Founded by Jacques Cousteau’s grandson, Philippe Cousteau, Jr., the Global Echo Foundation focuses on conservation and broad social issues.

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