The Curious Investor

Just as ETFs were becoming common place, one of the leading providers of ETFs, Barclay’s Bank, decided to throw a wrinkle into the whole thing. Barclay’s is the provider of iShares ETFs and recently launched a new class of exchange traded securities called the Exchange Traded Note (ETN). The use of ETFs and ETNs are exactly the same. They promise to give an investor returns equal to that of an index which they are linked to. The structure behind these securities, on the other hand, is wildly different.

ETFs represent a basket of stocks which must be tweaked and rebalanced regularly in hopes of keeping up with the index. ETNs represent senior, unsecured, unsubordinated debt securities issued by Barclay’s Bank. Basically, ETNs are a contract (read: “bond-like”) which Barclay’s issues with a promise to return exactly the return of an index minus fees. There are advantages and disadvantages to this new structure.

As you may be able to tell from the description, ETNs face no tracking risk. That is, you will always get the return of the index you’re buying. While ETFs are typically well constructed and offer very similar returns over the long-run, there always remains the possibility that an ETF issuer might miss the index returns. The problem with ETNs, however, is that they do not represent “real” assets like an ETF does. What they do represent, is ownership of a basket of notes. These are the contracts that Barclay’s has issued promising the returns of a given index. As a result, ETNs suffer from credit risk. Barclay’s assumes the tracking risk, but you assume that Barclay’s will remain solvent long enough to pay off the notes it has issued. The good news is that Barclay’s is one of the world’s pre-eminent financial houses and has a credit rating of AA by the S&P and AA1 by Moody’s. Barring an act of God or the acts of a rogue trader (see: Barings Bank), you should have nothing to worry about.

ETNs also offer tax advantages over ETFs in that ETFs typically have to perform certain short-term maneuvers in order to guarantee that the basket they hold properly represent an index. These reshufflings can be taxed at the short-term capital gains rate which can be as high as 35%. While there hasn’t been an official ruling on ETNs, Barclay’s claims that accountants it has consulted with have said that it is “reasonable” that ETNs be taxed only as contracts and as a result the holder of them will only be taxed upon selling them. Thus, if you hold longer than a year, you can ensure that you only pay a long-term capital gains tax of 15%. This is a little fuzzy for Currency ETNs as currency investments are typically taxed as income, but Barclay’s claims that ETN tax treatment should remain the same provided you follow certain steps.

So, can ETNs trade at a premium or discount? Well, this is where things get a little fuzzy. Since ETNs do not represent any underlying value, there is no NAV (net asset value). Barclay’s has created a metric known as “indicative value” which should represent the value of the notes it has issued and, as ETNs are traded on the open market, prices can differ from this value. As most ETNs are new and can be thinly traded, this can present a problem for those who choose to invest in ETNs. The removal of tracking risk in the underlying security doesn’t necessarily mean that the exchange-traded security will track perfectly. But, given that ETNs have a similar redemption policy (50,000 shares of an ETN can be redeemed for a Barclay’s note) to ETFs, the market price should not diverge from the indicative value of the notes by very much and provided that these ETNs become popular enough to trade on significant volume, they will likely provide better index tracking than ETFs. Factor in better tax treatment (though this may be subject to change) and ETNs look like a very intriguing new product.

As of right now, ETN offerings are nowhere near as robust as ETF offerings. As far as I can tell, they are only offered by Barclay’s under the name “iPath ETNs” and for the most part you can get them linked to commodities indexes, certain currencies, the MSCI India index (one of the few India options available to foreign investors), and a proprietary “Buy Write” index strategy. For more information, check out the iPath Website. Keep an eye out as Barclay’s filed for the launch of 9 new commodities ETFs about two months ago and it seems they’re continuing to be rather aggressive with the roll out of new products.

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