ETNs offer other choices

Exchange traded notes — close cousins to exchange traded funds — are starting to catch on with some financial advisers because they allow access to hard-to-reach markets.
AUG 25, 2008
By  Bloomberg
Exchange traded notes — close cousins to exchange traded funds — are starting to catch on with some financial advisers because they allow access to hard-to-reach markets. They provide access to "esoteric" investments that aren't necessarily suited to ETFs or mutual funds, said Lou Stanasolovich, president of Legend Financial Advisors Inc. of Pittsburgh, which has $360 million in assets under management. For example, investors interested in trying to make money in cocoa can invest in the iPath Dow Jones-AIG Cocoa Total Return Sub-Index ETN (NIB), issued by Barclays Bank PLC of London and marketed by Barclays Global Investors in San Francisco.
Advisers can also buy the Market Vectors-Chinese Renminbi/USD ETN (CNY), issued by Morgan Stanley and marketed by Van Eck Securities Corp., both of New York, if investors are interested in betting on the movement of Chinese currency. Such ETNs can be useful within "speculative portfolios," Mr. Stanasolovich said. Other ETNs such as the iPath Dow Jones-AIG Commodity Index Total Return ETN (DJP) or iPath S&P GSCI Total Return Index ETN (GSP) — both broad-market commodities ETNs — can be used in any portfolio to add diversification, said Jerry Miccolis, a senior financial adviser with Brinton Eaton Wealth Advisors, a Morristown, N.J.-based firm with $600 million under management.

ETN BENEFITS

The main benefit of holding them versus similar exchange traded products is that ETNs don't generate capital gains distributions and don't require investors to fill out a K-1 tax form, he said. ETNs — actually debt instruments linked to an index — are treated as prepaid forward contracts for federal income tax purposes. The tax treatment of ETNs, however, is being challenged. In a move some industry observers believe is an attempt to blunt the growth of ETNs, the Investment Company Institute, the Washington-based mutual fund trade organization, is lobbying to torpedo the tax advantages that ETNs enjoy over ETFs and mutual funds. As debt, ETNs are backed by the issuer. That can be a problem if the issuer runs into trouble, said Rick Miller, chief executive of Sensible Financial Planning in Cambridge, Mass., which oversees $170 million for clients. The collapse of The Bear Stearns Cos. Inc. of New York illustrates the point. Had JPMorgan Chase & Co. of New York not made a bid to acquire Bear, investors in the BearLinx Alerian MLP Select Index ETN (BSR), launched in July, might not be very happy. But JPMorgan did step in, and the ETN, which has more than $79 million in assets, still exists. That wasn't enough, however, to satisfy Mr. Miller. An early adopter of ETNs, he said the collapse of Bear spurred him to get out of ETNs altogether. "I just cannot, in good conscience, having been through what we have been through, put my clients at that extra risk," he said. It's an issue investors need to be aware of, Mr. Stanasolovich said. "Users of ETNs and structured notes will have to monitor the ratings of these companies [that issue ETNs] closely. We're always trying to be on top of that." Despite such concerns, ETN providers see an opportunity. As of Aug. 11, a total of 92 ETNs existed, 66 of which were launched this year, according to Morningstar Inc. of Chicago. Assets across all ETNs were just $6.83 billion, but ETN providers said it's too early to judge how successful ETNs will be based on assets. The first ETNs weren't launched by Barclays until 2006. And it wasn't until just recently that ETNs began to reach for a wider audience. An investor might choose an ETN over an ETF because the latter allows continuing, active management. Deutsche Bank AG of Frankfurt, Germany, earlier this month issued three Elements ETNs linked to the Benjamin Graham Intelligent Value Index. The ETNs, marketed by Nuveen Investments Inc. of Chicago, offer investors exposure to indexes based on the investment philosophy of Benjamin Graham, which seeks to identify businesses with strong, liquid balance sheets that are trading at a discount to their implied intrinsic value. At first glance, it appears to be an equity strategy well-suited to an ETF. The ETN structure, however, is a better fit for a specific type of investor because, unlike an ETF, an ETN doesn't have to divulge its holdings on a daily basis, said Mike Forstl, a managing director in the structured products group at Nuveen. Although portfolio holdings are made public only monthly, investors always know the price of the indexes to which the new Elements ETNs are linked, he said. This gives investors of Elements ETNs "a level of comfort" that they won't be copied, or compromised by market timers looking to jump in front of trades, Mr. Forstl said. E-mail David Hoffman at [email protected].

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