Keep On Trackin'

Exchange-traded notes (ETNs) are hot. That's right, ETNs — that's no typo. Do not confuse ETNs with their cousins, exchange-traded funds (ETFs), which because of their low cost and tax efficiency have become the financial world's iPod equivalent. According to the Investment Company Institute, ETFs have grown from virtually nothing to $485 billion in assets in less then two decades. And now Barclays Bank, the largest player in the ETF market, has introduced ETNs and says they may be more cost-effective than ETFs. While the ETNs are less than a year old, they already boast $2.7 billion in assets. So far Barclays is the only company that has launched the new investments, but Merrill Lynch plans to enter the field and other groups are sure to follow.

What makes ETNs intriguing is that they appear to be more tax efficient than ETFs. And the new notes can track indexes more closely than ETFs. So far Barclays has listed eight ETNs, including three that mimic commodity benchmarks and one that follows an index of the National Stock Exchange of India (NSE). Barclays soon hopes to bring out more products, perhaps including notes that track high-yield bonds and emerging market debt. The bank expects the rapid growth in its new notes to continue: “The ETNs have been very successful with financial advisors and registered investment advisors,” says Philippe El-Asmar, head of investor solutions, Americas, for Barclays Capital.

How ETNs Work

To appreciate the appeal of ETNs, compare Barclays India selection, iPath MSCI India Index, with a hypothetical ETF that follows the same benchmark. In order to track the index, the ETF must own all-or most-of the stocks in the benchmark. Buying the stocks involves some trading costs, which erode returns. Trading in India is particularly expensive because many of the stocks are small and illiquid. In addition, some of the stocks pay dividends. Under IRS rules, the ETF must distribute dividends to investors every year, resulting in tax bills for shareholders.

The trick with an exchange-traded note is that it does not own a portfolio of stocks; instead it is a senior secured note issued by Barclays. The value of the note tracks the benchmark. Because it owns no stocks, the ETN avoids the trading costs incurred by ETFs. Institutions can buy the ETNs directly from Barclays and pay the benchmark price plus expenses. Institutions who want to get out of the ETN can sell it to Barclays, which pledges to pay an amount exactly equal to the benchmark minus expenses. Retail investors can buy and sell the notes on stock exchanges. To make a trade, retail investors must go through a broker and pay the normal commission that is charged for any stock or ETF. Like all securities, the ETNs have a bid-ask spread on each trade, which typically runs from 5 to 10 basis points. But any price fluctuations away from the index should remain small. Because Barclays stands ready to redeem the securities, they should tend to track the index very closely.

In addition, because it doesn't own any stocks, the Barclays instrument does not distribute any dividends. This should mean that investors do not need to pay any tax bills-unless they sell the notes and face capital gains.

Some investors worry that the ETNs may be less tax efficient than they appear. Barclays has an opinion from its outside counsel, New York law giant Sullivan & Cromwell, that the notes do not appear to be taxable on an annual basis. Barclays points out that the ETNs resemble structured notes, which have existed for 15 years and do not create annual tax bills. Structured notes — issues that are customized for big clients — track benchmarks such as the S&P 500. But skeptics point out that the IRS has not yet ruled on the tax status of ETNs. “ETNs are young, and it is not yet clear how they will perform over the long term,” says Gus Sauter, chief investment officer of Vanguard Group, a competitor of Barclays in the ETF market.

If the IRS ruled in Barclays favor, ETN sales could explode. But even if the IRS delivers an unfavorable word-or never rules at all-the ETNs could still be enormously successful, say sources outside Barclays. “If people want exposure to India, for example, then the ETN is a way to get it,” says an accounting expert at New York Life who did not want to be identified. “If the tax advantage stands, that will be icing on the cake.”

Barclays has been careful to price its offerings a bit lower than competitors. Before the ETN appeared, investors who wanted exposure to India could buy India Fund, a closed-end fund, with 1.4 percent in annual expenses. The expense ratio on the Barclays ETN is 0.89 percent.

The Notes

A popular ETN is iPath GSCI Total Return Index, which tracks the Goldman Sachs Commodity Index and has an expense ratio of 0.75 percent. In contrast, Oppenheimer Commodity Strategy Total Return, a conventional mutual fund, charges 1.71 percent.

Besides the Goldman Sachs ETN, Barclays also offers commodity investors iPath Dow Jones-AIG Commodity Index and iPath S&P GSCI Crude Oil. Financial advisors have been turning to such choices as an efficient way to diversify portfolios. “For the most speculative 10 percent of a portfolio, it makes sense to include some commodity choices that won't be correlated with stocks or bonds,” says Jim Mullins, partner of Mullins Wealth Advisors in Fort Worth, Texas.

While the ETNs are appealing in many ways, there is one notable risk. If trading in a note stops, Barclays must step in and buy. This promise is only good as long as the bank is solvent. At the moment, the risk of default appears minuscule. Barclays is a giant institution with a AA credit rating from Standard & Poor's.

While Barclays is likely to bring out a string of ETNs, don't look for the notes to drive old-fashioned ETFs out of business. The two kinds of securities may appeal to different investors. Many investors like ETFs precisely because they make regular income distributions. Income-oriented savers like to get checks in the mail — even if they must pay taxes on the cash. On the other hand, investors who hate sending money to Washington may prefer ETNs. “There is room in the market for both ETNs and ETFs,” says El-Asmar of Barclays.

NEW KIDS IN TOWN

With their innovative secured-note feature, these exchange-traded notes could one day challenge ETFs in popularity.