Exchange Traded Notes Launching Rapidly, But What the Heck Are They?

By Tom Lydon | August 07, 2008 | 5:33 PM | 0 Comments

The pace of exchange traded note (ETN) launches has exploded so far in 2008. Just 22 were issued in 2007, but so far this year, we've seen 63. Meanwhile, the pace of exchange traded fund (ETF) issuances has slowed down, according to research by Shefali Anand at the Wall Street Journal.

ETNs, usually referred to as a cousin of ETFs, are a slightly different animal. Instead of being baskes of stocks, they're senior bank notes backed by the credit of the issuer. If you're buying an ETN, you're essentially buying a promise by the provider to pay the investor the amount reflecting a change in the underlying index. 

The credit risk is small, but it would be unwise to think that it isn't there at all. After all, look at all the venerable institutions that have struggled this year. It could be a reason that ETNs haven't been raking in the assets so far this year - investors could be skittish about taking on credit risk in such uncertain times.

ETNs also have slightly different tax treatment than ETFs. Investors should treat ETNs as prepaid contracts, and any difference between the sale an purchase is classified as capital gains. There's still some ongoing debate about the tax treatment for ETNs. The IRS has ruled on the issue as far as foreign currency ETNs go, but they're still discussing the matter as far as other types of ETNs go.

An attractive feature of ETNs is their lack of tracking error - any difference between the ETN and its underlying index is borne by the issuer. With ETFs, the difference is borne by the investor.

We spoke with Phillipe El-Asmar, head of solution sales, Americas, at Barclays Capital, several weeks ago, and he explained that ETNs are meant to provide access to harder-to-reach markets. For example, long before there were any ETFs giving investors access to India, there was the iPath MSCI India ETN (NYSE: INP).

Barclays launched the first ETN, an iPath product, in 2006. Since then, the number of providers has grown to 11. El-Asmar says they work with their sister company, Barclays Global Investors, to prioritize and see where complementary products can be created.

Most ETNs have fewer than $100 million in assets. Collectively, the marketplace for them has $7.2 billion, Ian Salisbury for the Wall Street Journal noted in July. We think that for the most part, it's that the markets have been challenged and there's not a lot of new money out there. 

Many ETNs represent commodities, but investors had likely been putting their money in commodity funds that have been established longer. When the market makes a turnaround, these products might capture the attention of investors, who will appreciate them for the unique areas they cover.

Among the ETN launches we've seen this year are:

   •  JP Morgan Chase & Co. ETN 130/30 (NYSE: JFT)
   •  iPath Dow Jones-AIG Platinum Total Return Sub-Index (NYSE: PGM)
   •  iPath Dow Jones-AIG Coffee Total Return Sub-Index (NYSE: JO)
   •  PowerShares DB Base Metals Short ETN (NYSE: BOS)
   •  PowerShares DB Base Metals Long ETN (NYSE: BDG)
   •  Market Vectors Double Long Euro ETN (NYSE: URR)
   •  UBS E-TRACS CMCI Agriculture (NYSE: UAG)
   •  UBS E-TRACS CMCI Food (NYSE: FUD)

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