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Portfolio > ETFs

The Latest Notes on Notes

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Barclays Global Investors was among the earliest providers of exchange-traded funds (ETFs) in the U.S. market, but now has its sights set on another cutting-edge solution: exchange-traded notes, also known as ETNs.

BGI launched the first series of iPath ETNs last year; by June 2007, the products had attracted $2.6 billion in assets. What’s the appeal? How do they compare with ETFs? And what are the risks? Before we answer these questions, let’s recap some of the key features.

ETNs are not registered as mutual funds or ETFs, but are debt instruments. They pay a return linked to the performance of a single currency, a commodity or an index. The iPath notes come with 30-year maturities and are senior unsecured debt issued by Barclays Bank.

Like ETFs, ETNs can track recognizable stock and commodity indexes as well as currencies; they’re also bought and sold with brokerage orders just like traditional ETFs. However, ETNs incorporate an arbitrage feature to keep market prices closely hinged to the intrinsic value of the benchmarks they track. Large financial institutions that accumulate 50,000 notes can redeem them back to Barclays on a weekly basis in order to take advantage of any premium or discounts that may emerge.

As debt securities, ETNs do not have a net asset value (NAV). Instead, their daily indicative value is based upon index levels published daily by the index provider.

Liquidity and ExposureSince ETNs trade on major stock exchanges, they can be bought and sold in the secondary market. Another route to liquidity is to simply hold the note until maturity. Each iPath note has a maturity period of 30 years. Even though the first series of iPath ETNs don’t mature until 2036, this could fit the bill for an investor with a long-term investment horizon. Investors that opt to keep their notes for the full duration receive a cash payment of the underlying index’s performance calculated from the trade date to maturity (applicable fees are deducted at this time).

Perhaps the greatest appeal of ETNs is that investors can obtain market exposure to asset classes in which they cannot directly invest because of a lack of accessibility, investment restrictions or other complexities. “The operating structure of the ETN gives us far greater ability to bring products to market that would be incredibly difficult — if not impossible — under a traditional ETF structure,” explains Noel Archard, head of product development at BGI.

Over the past several years more financial advisors have been incorporating commodities exposure into their client’s mostly equity- and bond-heavy portfolios. Two contributing factors fueling this boom are a bull run in commodity prices and the explosion of investment products like ETFs and ETNs to track them. For example, the iPath ETNs include three commodity-linked notes, three currency notes, one emerging market note, and one that follows the CBOE S&P 500 BuyWrite Index.

The iPath commodity notes offer exposure to the DJ-AIG Commodity Index Total Return (NYSE: DJP) or the S&P GSCI Total Return (NYSE: GSP) index. For advisors with a more narrow focus on energy, Barclays also supports a commodity ETN based on the S&P GSCI Crude Oil Total Return (NYSE: OIL), which is tied to the performance of an unleveraged investment in West Texas Intermediate crude futures plus the excess interest of collateralized assets in Treasuries.

With regard to cost, note holders pay 0.75 percent in annual expenses, roughly comparable to corresponding commodity-linked ETFs and extremely competitive compared to commodity mutual funds like the Pimco Commodity Real Return (PCRDX), which carries an expense ratio of 1.24 percent.

Going Overseas (and Beyond)Currency may be a potential source of risk and return, but it can also act as a diversification tool to hedge against passive currency exposure. On the currency front, the iPath notes offer exposure to the euro, British pound and Japanese yen.

In terms of foreign equities, Indian stocks, for example, have been hands-off for U.S. investors because of restrictions on foreign ownership, and funds tracking them tend to be expensive. A viable alternative to these funds is the iPath MSCI India ETN (NYSE: INP), which charges annual expenses of just 0.89 percent and tracks 69 of the largest companies in the domestic Indian market, representing over 85 percent of the free-float adjusted market cap in the country.

At the end of May, Barclays launched the iPath CBOE S&P 500 BuyWrite Index ETN (AMEX: BWV). The note tracks the total return of a hypothetical buy-write, or covered call strategy, on the S&P 500 Index. This can help reduce volatility in an investor’s stock portfolio by providing premium income from written call options that can, to a limited extent, offset losses from downside market performance.

Historically, the CBOE S&P 500 BuyWrite Index has generated comparable returns to the S&P 500 Index but with two-thirds the risk. The five-year annualized return through the end of March for the BuyWrite Index was 9.31 percent versus 12.49 percent for the S&P 500 over the same period.

Advantages and Risks”The value of ETNs is most advantageous in a taxable portfolio and in asset classes that pay ordinary income or short-term capital gains,” says Rick Ferri, CEO of Portfolio Solutions. He observes that tracking commodities via futures indexes or tracking currencies via short-term interest-bearing instruments is not very tax-efficient in an ETF product shell, but with an ETN structure they are.

ETNs aren’t forced to make taxable distributions to their shareholders either. In a taxable investment account, mutual fund and ETF investors may get stuck with a capital gain distribution even though they haven’t sold their investments.

As good as all of this may sound, ETNs do carry an element of taxation risk. The IRS has not made an official ruling on how these instruments should be taxed, but for now, ETNs are classified as prepaid contracts. This means investors should only realize a capital gain or loss upon the sale, redemption or maturity of their ETN.

Moreover, iPath ETNs are not rated, but instead rely on Barclays’ financial ratings. This raises another element of uncertainty; those that don’t believe issuer credit risk is a big deal might want to think again. In a worst-case scenario, the best financial institutions can spiral out of business or have their credit ratings dragged through the mud. As debt securities, ETNs would be very much affected by this.

While total financial collapse isn’t an everyday event, reductions in a company’s credit rating aren’t rare. Barclays is currently rated AA by S&P and Aa1 by Moody’s. A drop in the company’s credit rating could hurt the credit backing the firm’s ETNs.

Referring to an adverse credit rating opinion, Michael McClary, director of investment advisor services of ValMark Securities, notes, “This type of event could create a large discrepancy between what the market value of the ETN is and what the underlying index has appreciated to during a respective period of growth.”

Like a lot of firms, ValMark is sold on ETFs, but McClary’s been hawking ETNs. “I would be interested to see ETNs that track fixed-income indices, which would be a very tax-efficient way to get exposure to bonds,” he says. He may indeed get his wish.—

sRon DeLegge is the San Diego-based editor of


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