ETF Talk: The Rise of ETNs

One of the greatest satisfactions that I receive is from highlighting key investment trends and passing them along to you before the rest of the investing world discovers them. A key development that I want to share with you this week is the rapid growth of exchange-traded notes (ETNs).

Any regular reader of my ETF Talk features knows that I love exchange-traded funds. Indeed, if you have any questions about ETFs that you’d like me to answer, click here. Today’s focus on ETNs is intended to profile a relatively new way to invest in sectors such as commodities.

ETNs started to surface last year, and they now are beginning to proliferate. How quickly are ETNs growing? NYSE Euronext had just seven ETNs listed on its exchange on June 30 last year. On the same date this year, the exchange had 76 ETNs registered. That’s quite a jump!

Why are ETF providers rolling out their own ETNs? One reason is that the structure of ETNs avoids certain disadvantages of ETFs in investing in particular asset classes, such as commodities. ETFs based on commodity futures can incur potentially big tax liabilities before gains have been realized by the shareholder, while ETNs currently only incur tax liabilities upon the sale of shares. As a result, ETNs quickly are becoming viable alternatives to commodity ETFs.

The key is to know when to use ETNs. ETFs still offer enviable diversification and low expense ratios when compared to mutual funds and virtually any other investment. An important consideration with ETNs is that they take the credit risk of the issuer, while ETFs do not. For that reason, you need to be careful to use creditworthy ETN issuers. It is not unlike trying to ensure you only buy an annuity from a financially strong provider.

ETNs, unlike ETFs, do not own a slice of an investment portfolio. ETNs are forward contracts that a provider such as Barclays or Deutsche Bank guarantees to pay off at maturity, based on the performance of an index that the ETN tracks. ETNs, in contrast to ETFs, are issued as senior debt by the fund company. ETNs track the performance of their underlying indexes and the issuer deducts a management fee. ETFs also deduct a management fee but their performance can fall below that of a given index.

In the ETF Talk feature that we distributed on April 30, my team and I reported our discovery of a significant tax problem for individual investors who use taxable dollars for their commodity ETF purchases. If you trade such commodity ETFs in tax-deferred accounts, you should be able to escape the tax problem that affects investors in funds such as PowerShares DB commodity ETFs and others that do not take delivery of the commodity itself.

For commodity investors who want an alternative to ETFs to avoid receiving any K-1 forms that could include high tax liabilities, Deutsche Bank, for example, is offering ETNs that invest in commodities. Barclays is doing so, too. Other fund companies also are getting into the action. A plus for tax-conscious investors is that the returns of ETNs are reported on 1099 forms. In addition, the ETNs have the same investment reporting transparencies as ETFs. Some of you may recall that I highlighted key advantages of commodity ETNs in my April 30 ETF Talk feature, ETF Talk: Avoid the Tax Trap of Commodity ETFs.

The growing popularity of ETNs was on display June 25, 2008, when 11 new Barclays iPath Exchange Traded Notes were listed on NYSE Euronext. Those ETNs included one linked to the global price of carbon. iPath Global Carbon ETN (GRN) is the first ETN designed to provide investors with exposure to greenhouse gas prices tracked by the Barclays Capital Global Carbon Index Total Return.

The other 10 new Barclays ETNs unveiled on June 25 also offer investors exposure to sub-indices of the Dow Jones-AIG Commodity Index Total Return. The following table lists all of the new funds and their individual tickers.

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Jim Woods is a 30-plus-year veteran of the markets with varied experience as a broker, hedge fund trader, financial writer, author and newsletter editor.

His books include co-authoring, “Billion Dollar Green: Profit from the Eco Revolution,” and “The Wealth Shield: How to Invest and Protect Your Money from Another Stock Market Crash, Financial Crisis or Global Economic Collapse.” He’s also ghostwritten many books and articles, as well as edited content for some of the investment industry’s biggest luminaries. Read more about Jim Woods.

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