The Investment Company Institute, the powerful mouthpiece of the mutual fund industry, is trying to torpedo the tax advantages of exchange traded notes, and industry insiders think that it has a pretty good chance of being successful.
"I think there's great empathy for the ICI among lawmakers," said one insider involved in the fight against the Washington-based ICI, who asked not be identified. "I think the tax writers would like to do something eventually."
Paul Schott Stevens, president and chief executive of the ICI, wrote a letter to the House Ways and Means Committee last month urging the enactment of legislation that would require current accrual of income on ETNs.
"The legislation that we seek would eliminate the unwarranted and unintended tax advantages that ... ETNs appear to have over mutual funds," he wrote.
Issued as debt by a bank or investment bank, ETNs are treated as prepaid forward contracts for federal income tax purposes, meaning that an investor does not realize any income or recognize any gain until the ETN is sold.
The result is that an investor holding the ETN for more than a year is taxed at the 15% long-term capital gains rate.
That's different than the tax treatment of investors who hold exchange traded funds or mutual funds. Both are taxed on realized income and recognize gains on an annual basis.
The ETF structure, however, minimizes annual distributions, which is perhaps why the ICI seems concerned mostly about mutual funds.
"The concern is the tax disparity is unfair to mutual fund shareholders," said Edward Giltenan, a spokesman for the ICI. "The potential danger is, investors could be driven to a product based on one factor [taxes] as opposed to its investment merits."
Others, however, suggested that investors aren't the ICI's chief concern.
"The ICI has a vested interest in putting the damper on any competitor or competitor products," said Jim Lowell, Needham, Mass.-based editor of Forbes ETF Advisor, a monthly newsletter.
There's no doubt that ETNs are starting to catch on.
The iPath exchange traded notes from
Barclays Bank PLC of London — the largest seller of retail ETNs — have amassed more than $4 billion since making their debut in June 2006.
The
Goldman Sachs Group Inc. of New York launched its first ETNs in August and
Deutsche Bank AG of Frankfurt, Germany, joined the party in October.
Some financial advisers, however, said that if the tax advantages of ETNs go away, it could put the brakes on any further growth.
The tax advantage "is the primary reason we use ETNs," said Lou Stanasolovich, president of Legend Financial Advisors Inc. of Pittsburgh.
That's what first attracted David Elan, principal with Boston-based financial advisory firm Windward Investment Management Inc., to ETNs.
He decided to try out the iPath GSCI Total Return Index ETN, which tracks the
Goldman Sachs Commodity Index, when it made its debut in 2006, because it was more tax friendly than the commodities mutual fund he was using at the time: the $1.8 billion Oppenheimer Real Asset Fund, advised by OppenheimerFunds Inc. of New York.
The Securities Industry and Financial Markets Association of New York and Washington is concerned enough about the ICI's attack on ETNs that its president and chief executive, Marc E. Lackritz, sent a letter to Ways and Means last month rebutting the ICI's position on ETNs.
"The request to change the tax treatment of ETNs is driven by concerns over competitiveness and not by sound tax policy," he wrote. "SIFMA believes these concerns are unfounded, and we urge Congress to reject increasing taxes on investors."
It may be hard, however, for Congress to resist.
It is considering legislation to protect taxpayers with moderate income from having to pay the alternative minimum tax, but doing so would result in lost revenue.
"If they decide to patch the AMT, then they need to raise the money elsewhere," said Thomas Humphreys, a New York-based partner at Morrison & Foerster LLP of San Francisco.
That means Congress may seriously consider the ICI's suggestion, he said.
It appears that Barclays may already be expecting the worst.
"We agree with SIFMA," Christine Hudacko, a spokeswoman for San Francisco-based Barclays Global Investors, the Barclays unit responsible for distributing ETNs in the United States, said with regard to the tax treatment of ETNs.
But she made it clear that ETNs would still be an attractive product if Congress were to take away the tax advantage they have over ETFs and mutual funds.
"The reason we came out with the iPath ETNs was because our clients were seeking access to markets that they couldn't reach," Ms. Hudacko said.
For example, ETNs give investors access to commodities, currencies and emerging markets.
In May, Barclays unveiled an ETN — the iPath CBOE S&P 500 BuyWrite Index ETN — that provides investors with access to a covered-call-writing strategy.
ETNs can provide such access more easily than ETFs or mutual funds because they are a type of debt security backed by the issuer built to replicate an index. That means they don't actually own the underlying index they are trying to track.
There's no doubt that even without the tax advantage they currently enjoy, ETNs will remain popular with advisers who want access to hard-to-reach markets, said Robert N. Gordon, chief executive of Twenty-First Securities Corp., a New York-based brokerage firm.
"I think that ETNs will live if the law is changed," he said.
But the still-nascent ETN industry could find its growth limited, Mr. Gordon added.
David Hoffman can be reached at [email protected].
