If you think the menu of exchange-traded funds has gotten big, you should take a gander at exchange-traded notes. The number of notes has jumped to around 80, up from just a handful of choices a few years ago.

What are ETNs and how do they work?

To recap the basics: ETNs are debt instruments that pay a return linked to the performance of a single currency or commodity or an index of securities. The financial institutions that back ETNs promise to pay this return, minus annual fees. As debt, ETNs do not trade at or have a net asset value (NAV). Instead, their daily indicative value is based upon the index level that is published daily by an index provider or media outlet. The purpose of calculating the indicative value of an ETN is to approximate the intraday economic value of the note.

Financial advisors familiar with ETFs will see that ETNs share many similarities. For example, ETNs are bought and sold with brokerage orders just like traditional ETFs. Another important characteristic of ETNs is they have an arbitrage feature that’s designed 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 the issuing institution in order to capitalize on any premium or discounts that may exist.

Early AdoptersBarclays Global Investors (BGI) launched the iPath ETNs in 2006. The notes began as a small group of eight choices and have now grown into a menu of 26. The iPath notes come with 30-year maturities and are senior unsecured debt issued by Barclays Bank

The bulk of iPath notes focus on individual commodities such as coffee (JO), natural gas (GAZ) and copper (JJC). Other notes take a broader approach by focusing on a group of commodities. The precious metals notes (JJP), grains (JJG) and energy (JJE) take this approach. Still, other notes are concentrated on stocks (INP) or currencies (ICI).

“When we hear that clients need access to a particular asset class, we consider the investor’s experience, the internal portfolio management and the likely liquidity on the secondary market. Typically all parties are better off with an ETN structure for harder-to-reach markets,” said Noel Archard, iShares/iPath product development at Barclays Global Investors.

“Overall I maintain an approximate portfolio weight of 3.35 percent in three ETNs, all iPath: India and two commodity funds,” states R. David Telling, Jr., Managing Member of Telling & Company based in The Woodlands, Texas.

He continues: “Commodity, currencies and difficult-to-trade equity markets such as India make the ETN at the present the preferred instrument.”

Liquidity OptionsAs is the case with other debt securities like government or corporate bonds, ETN investors are not required to hold their notes through maturity. Since ETNs trade on major stock exchanges, they can be bought and sold in the secondary market. By selling an ETN prior to maturity, the investor forgoes the right to receive the full value of the index’s return at maturity.

Another route to liquidity is to simply hold the note until maturity. Most notes have 30-year maturities. Investors that opt to keep their notes for the full duration receive a cash payment calculated from the trade date to the ending period or maturity date. Applicable fees are deducted and reduce the value of their final payment.

One last liquidity feature consists of note redemptions, which are usually reserved for financial institutions with large note blocks of 50,000 or more.

Multiple AssetsPerhaps the greatest appeal of ETNs is that investors can obtain market exposure to asset classes in which they cannot directly invest because of 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,” says Archard.

Over the past several years more financial advisors have been incorporating commodities exposure into their clients’ portfolios. Two contributing factors fueling this boom are a bull run in commodity prices and the explosion of investment products, including ETFs and ETNs, aiming to track them.

The iPath notes offer exposure to two broad based commodity indexes in the DJ-AIG Commodity Index Total Return (DJP) and the S&P GSCI Total Return Index (GSP). The notes charge an annual fee of 0.75 percent.

Another area some advisors have been examining is currencies. Movements in foreign currencies do not always coincide with foreign equity markets. As such, currency may be a potential source of 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 (ERO), British pound (GBB) and Japanese yen (JYN). Also, Van Eck’s Market Vectors offer the Chinese renminbi (CNY) and Indian rupee (INR).

Hedge Fund StrategiesIn May, First Trust Advisors and J.P. Morgan introduced an ETN that uses a 130/30 strategy (JFT). Such strategies typically begin with a group of selected stocks from an index like the S&P 500 or Russell 1000. The portfolio manager invests 100 percent of the fund’s assets in a screened list of chosen stocks and then simultaneously sells short 30 percent of the undesirable stocks. The cash proceeds generated from these short sales are redeployed back into the 100 percent long stock holdings. The fund’s stock allocation then becomes a mix of 130 percent long and 30 percent short.

Over the past several years, the 130/30 approach has become one of Wall Street’s hottest investment strategies, especially with hedge funds. Having notes that utilize hedge fund strategies is a significant step. No longer are such techniques exclusively available to just a small group of privileged investors.

Among the advantages of notes that use hedge-fund-like tactics are lower fees, greater liquidity and no minimum investment requirements.

Fees: One of the significant barriers of hedge fund investing is high costs. Instead of paying hedge fund managers annual management fees of 2 percent and 20 percent of profits, JFT charges just 0.95 percent.

Investment minimums: Hedge funds, especially ones piloted by hotshot managers, can have steep initial investment requirements. Also, certain investors, because they don’t have the minimum net worth requirements may not be able to invest in hedge funds. ETNs skirt both of these issues.

Liquidity: With regard to liquidity, some hedge fund managers may charge redemption fees for early withdrawals or in extreme circumstances ban withdrawals. Contrast this with ETNs. As long as the market is open for business, ETN investors can enter and exit their positions.

Inverse Performing NotesThe number of inverse performing ETNs is still small but offers some interesting opportunities. Currently there are nine commodity-focused notes.

InvescoPowerShares has a series of notes that short various commodities. If the commodities they track fall in value, the notes are designed to increase. While some of the ETNs don’t use leverage, others are designed to magnify inverse performance.

To illustrate, the PowerShares DB Agriculture Short ETN (AGA) aims to deliver 200 percent of the opposite monthly performance of the Deutsche Bank Liquid Commodity Index – Optimum Yield Agriculture. The index is composed of futures contracts on four agricultural commodities and weighted as follows: Corn (25 percent), Soybeans (25 percent), Sugar (25 percent) and Wheat (25 percent). Because agricultural commodities have been climbing, AGA has declined by 10.5 percent since the notes were introduced in April. (Note: All performance figures in this article are through the July 10, 2008 market close.)

If you aren’t comfortable going opposite individual commodity sectors, the PowerShares DB Commodity Short ETN (DDP) shorts the broader basket of commodities. The underlying index is composed of light sweet crude oil (35 percent), heating oil (20 percent), gold (10 percent), aluminum (12.5 percent), corn (11.25 percent) and wheat (11.25 percent).

One portfolio strategy to use DDP would be to hedge a commodities position. Suppose your client has enjoyed substantial investment gain in a long commodity fund like GSG or DBC. Here’s the problem: Your clients don’t want to risk seeing their paper gains evaporate, but they also don’t want to sell. How can you help them with this dilemma? Instead of selling the long commodities position and incurring capital gains tax, the holdings can be hedged with DDP. Any decrease in the value of commodities would be offset by corresponding gains in the inverse performing note.

The DB Commodity ETNs are unsecured debt securities issued by Deutsche Bank’s London Branch.

Other Strategies Last year Barclays launched the iPath CBOE S&P 500 BuyWrite Index ETN (BWV). The note tracks the total return of a hypothetical buy write, or covered call strategy, on the S&P 500 Index. This strategy 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 in the equity portfolio on which the options are sold.

Historically, the CBOE S&P 500 BuyWrite Index has generated comparable returns to the S&P 500 Index but with two-thirds the risk. Through the first six months of the year, BWV was down just 6.29 percent versus negative 12.37 percent for the S&P 500 over the same period.

Tax ConsiderationsThe real value of ETNs is for asset classes that pay ordinary income or short-term capital gains. For example, commodity futures inside an ETF structure aren’t very tax efficient, whereas with ETNs they are. Unlike mutual funds or even ETFs, notes linked to commodities aren’t required to make taxable distributions to their shareholders. Good as it sounds, this feature could be changing in the future.

In December 2007, the U.S. Internal Revenue Service issued an adverse tax ruling on currency-linked ETNs. The rule stated that any financial instrument linked to a single currency — regardless of whether the instrument is privately offered, publicly offered or traded on an exchange — should be treated like debt for federal tax purposes. This means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the holder sells any such financial instrument, including an ETN, or the contract matures. It also means that gain or loss on sale or redemption will generally be ordinary, and investors will not be able to elect capital gain treatment.

As things stand, ETNs linked to commodities and equities 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. Until the IRS gives more forthright guidance on the tax treatment of ETNs, the risk remains the agency could render an adverse tax ruling.

Credit RiskWhile financial institutions backing ETNs may be quick to downplay the significance of credit risk, advisors shouldn’t. Even the best-run financial institutions can spiral out of control or have their credit ratings dragged through the mud.

“Though I believe that ETNs have the capability of reducing tracking error, I yet remain very cautious about an unsecured/non-collateralized structured investment instrument and generally prefer an asset-backed instrument,” says Telling.

In worst-case scenarios, some financial implosions happen so swiftly and completely that no one could’ve foreseen trouble coming.

In 1995, London-based Barings Bank was brought down by a rogue trader named Nick Leeson who racked up $1.4 billion in losses. Up until then, Barings was the oldest merchant bank in the United Kingdom, seemingly invincible and arguably the most prestigious.

What about now?

“Credit risk is a major issue, especially in the current market environment where financial institutions continue to write down assets and are desperately seeking capital infusions,” says Matthew Rice, CFA, CAIA, principal and chief research officer at DiMeo Schneider & Associates. “Bear Stearns showed us how quickly a financial institution can implode once a panic sets in.”

Total financial collapse may not be out of the question, but it’s probably a rare event. A reduction in an ETN backer’s credit rating is perhaps an even greater possibility. This type of event would likely create a discrepancy between an ETN’s market value and how much its underlying index has appreciated. A large discount would create an unwelcome scenario for investors that bought at par. Conversely, a discount could create an arbitrage opportunity if the institution backing the ETN has its financial ratings upgraded.

Rice adds: “In our opinion, the advantages probably do not outweigh the warts of the ETN structure for most investors. When you buy asset class exposure through an index, you presumably want the asset’s risk premium and are willing to tolerate the index’s volatility. However, ETNs layer concentrated counterpart risk (of a single financial institution) on top of the asset’s risk. The tail risk of a single counterparty default is very difficult to quantify, but can turn the improbable (default) into an extraordinarily high consequence (and unwelcome) event for the ETN investor.”

The message is clear: ETNs are very much affected by the creditworthiness of the financial institution backing them.

Tracking Error Advantage Tracking error happens when a fund’s performance deviates from its underlying index. This can take place for various reasons such as a fund manager’s inability to execute changes within an index, or a fund’s investment restrictions.

With an ETN, the issuer has the obligation to deliver the exact return of the underlying index, minus fees which accrue daily. Therefore, ETNs deliver minimal tracking error compared to competing investment products.

Summarizing ETNsAdvisors should consider the full spectrum of benefits and drawbacks of ETNs. How will these products fit into your client’s portfolios? Do they help you to execute a specific investment strategy? Or maybe they help you to better diversify your clients.

Whatever the case, being familiar with ETNs can help you to stay ahead of the curve.

Ron DeLegge is the San Diego-based editor of www.etfguide.com.