From the February 2007 issue of Wealth Manager Web • Subscribe!

February 1, 2007

Notable Debut

In the beginning, there was the closed-end fund. Next came the open-end mutual fund, followed by the exchange-traded fund (ETF). And now, the exchange-traded note (ETN). Are we witnessing the next leg of the investment revolution? Will ETNs take investors where ETFs fear to tread? Do ETNs represent the final frontier of the securitized investment portfolio?

Such questions promise to resonate in the wake of the launch last June of the first ETN. On the surface, however, the similarities between ETNs and their ETF cousins appear to outweigh the differences. Both are exchange-listed instruments that are traded throughout the day. The rules for shorting ETNs and ETFs are identical, and so both can be sold short on upticks or downticks. Perhaps the most important similarity is that each is designed to deliver the performance of a particular index, less fees. That's where the similarities end.

Deciding if the differences are substantial, irrelevant or something in between promises to be a lively debate in 2007 and beyond. Indeed, each security type has its own set of pros and cons, and so one or the other may be the superior choice for different investors at different times.

For the moment, such discussions are still somewhat academic because, as we write, only four ETNs are available, and all are less than a year old. As the population grows, and investors become more comfortable with these securities, ETNs may become the new new thing in investment circles--assuming they survive and prosper.

The nascent ETN market recalls a similar state of affairs in 1993, the year of the first ETF launch. The S&P 500 Spider ETF arrived in the U.S. mostly to yawns at first. In the years since, ETFs have ridden an impressive wave of popularity. As of this past October, 315 ETFs in the U.S. held assets of $383 billion, according to the Investment Company Institute.

Is a similar trajectory of success on tap for ETNs? If so, will it come at the expense of ETFs, mutual funds, or both? Perhaps the market can sustain growth for all three fund types. Whatever the answer, it's too early to say, although it's not too early to assess the opportunities that ETNs represent.

But first, a quick digression into ETN basics. The story began in June 2006, when Barclays Bank PLC rolled out two ETNs, followed by a third in August and a fourth in December, all under the iPath brand (iPathETN.com). More ETNs are coming, Barclays says. As for the current quartet, three are focused on commodities and one on India's stock market. All trade on the NYSE (see Table 1).

The key difference between ETNs and ETFs is their respective design. Most ETFs are built as investment companies ? la mutual funds. As such, ETFs represent ownership in a basket of securities. ETNs, by contrast, are promises to deliver a return that tracks an index. To be precise, iPath ETNs are debt securities issued by Barclays--senior, unsecured, unsubordinated 30-year debt securities.

After 30 years from inception, the ETNs will liquidate and pay an amount equal to the change in the underlying index over the three decades. In the interim, investors can buy and sell ETNs at market prices. The expectation is that market prices will closely track the respective indicative value, an intraday measure that's intended, but not guaranteed to "approximate the intrinsic economic value of each iPath ETN," according to Barclays' Web site. For large investors, Barclays will redeem ETNs (lots of 50,000 or more units) on a weekly basis.

ETFs and ETNs, in short, are the equivalent of equities and bonds, respectively. The former represents an equity interest in the underlying assets; the latter is a debt security that entitles the owner to a financial promise from the issuer. Reflecting that fundamental difference in security structure, ETNs are registered under the Securities Act of 1933 and ETF registration falls under the Investment Company Act of 1940.

The regulatory differences carry some real-world consequences. ETNs, like any debt security, carry credit risk--a distinguishing characteristic absent in ETFs. Admittedly, ETN credit risk is quite low, at least with the iPath series. Barclays Bank PLC, a subsidiary of the 300-year-old London-based Barclays PLC, is one of the world's largest financial services companies and is best known in the United States as the leading ETF sponsor under the iShares brand. Nonetheless, large, established banks aren't immune to risk, and sometimes they even go under. A notorious case of recent memory is Barings Bank, an otherwise sound entity that suddenly and unexpectedly collapsed in 1995 after one of its traders illegally ran up a $1.4 billion loss in the futures markets.

That said, the risk of default at Barclays is about as low as it gets in the corporate world, according to the credit-rating agencies. Standard & Poor's gives the iPath ETNs a credit score of AA and Moody's assigns them an Aa1 rating--in each case, just one notch below the highest grade.

But low isn't zero. The issue is less about default than pricing: Does minimal credit risk for an ETN still require compensation? In particular, will investors demand a price discount relative to the underlying value of a theoretically risk-free ETN?

Whatever the answer, one might counter that ETN credit risk is partially offset by more-favorable tax treatment relative to some ETFs. For example, gains or losses on some commodity-linked ETFs are realized at 60 percent long term and 40 percent short term, regardless of the holding period, because of the futures contracts in the portfolios. For ETNs, the 60/40 tax treatment doesn't apply to gains and losses; rather, ETN gains and losses are either short or long term, based on the holding period. In other words, holding an ETN in a taxable account for more than a year can offer superior tax treatment relative to an identical trade with certain ETFs.

But don't carve that in stone just yet. ETNs are a recent arrival on the investment scene, so that hard-and-fast IRS rules on the securities may evolve. Yes, Barclays has hired tax lawyers to back up its expectation that ETNs won't be subject to the 60/40 treatment. Nonetheless, Barclays advises in its literature that IRS rules on ETNs could change. Such is life for newly minted investment products.

Over time, the real advantage of ETNs is likely to be the ability to tap returns from asset classes and investment concepts otherwise impractical in ETFs and mutual funds. To date, there are only hints of ETNs' capabilities. The first three ETNs retrace previously settled terrain in either mutual funds, ETFs or both. But the ETN revolution has only just begun.

Philippe El-Asmar, a managing director and head of investor solutions at Barclays Capital in the Americas, says the firm will launch more ETNs tracking emerging market equities, currencies (euro, pound and yen), and each of the nine subsectors that comprise the Dow Jones-AIG index.

Beyond that is only speculation, although conceptually the future holds even more promise for using ETNs to deliver exotic markets to the masses. Arguably, ETNs were designed for no less. They do, after all, extend a promise to deliver a particular return rather than promising to hold a particular set of securities.

The relative freedom of ETNs to go where ETFs can't or won't raises some intriguing possibilities, says Ron DeLegge, editor of the ETFGuide.com. He notes that there are a number of indices that might one day work as the basis for ETNs, including benchmarks that track regional housing markets, art and collectible cars. ETNs may be the mechanism that turns otherwise obscure asset classes into securitized products, he says.

As a result, ETNs may ultimately offer investment strategists the spice that's been missing for all but the largest accounts. For everyone else, a growing list of strange, new ETNs may be as confusing and potentially dangerous as the products are potentially liberating.

Then again, ETNs aren't really new, but are just the latest twist on the so-called structured-product concept. Structured products, which have been around for years, are listed on the NYSE, AMEX and Nasdaq and offer a rainbow of financial engineering in a listed-security wrapper.

On the American Stock Exchange, for instance, structured product listings go back to at least 1990, says Richard Mikaliunas, senior vice president in the exchange's capital markets division. The Amex now claims nearly 400 structured products with a total market value of about $14 billion, he reports. Many are debt securities (just like ETNs) that promise a performance profile based on an index or some other financial outcome.

As is typical with structured products, the prevailing trend over time is innovation. Among the more intriguing structured products that reportedly received SEC approval but, for timing reasons, didn't make it to a listing, was a security that paid out a share of New York Yankee Derek Jeter's contract to shareholders.

If more choices mean more opportunity, the future could hardly look brighter for investment strategists. The challenge is turning a bigger menu of risk factors into superior risk-adjusted performance in a portfolio setting. The more things change....

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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