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Once upon a time there were two hot new investment products that promised to revolutionize asset management. Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs) are both are open ended investable funds that are traded on exchanges like common stocks and offer investors tax advantages to mutual funds. Both securities typically have low expense ratios, track passive indexes, and can be used for exposure to nearly any asset class. But although both had promising futures before the financial crisis, one significant difference between the two may doom ETNs to failure while propelling ETFs to new heights.

ETFs are structured as equities, while ETNs are structured as debt. When an ETF closes or the issuer goes bankrupt, the underlying assets are sold and the proceeds returned to investors. The process isn't perfect, but for the most part investors in a defunct ETF get their money back. Holders of ETNs, on the other hand, are treated as creditors in a bankruptcy proceeding. There is no guarantee that ETN investors will get a single dime of their money back in the event of an issuer's collapse.

All of this was purely theoretical until Lehman Brothers - the issuer of three small ETNs - collapsed last September. The investment bank's assets were bought by Barclays, whose iPath funds pioneered the ETN market. Investors hoped that Barclays would protect the market's reputation by honoring Lehman's notes, but soon after the transaction was completed word came down that the British bank would not be picking up Lehman's ETN obligations. Investors in those three notes were left at the mercy of Lehman's bankruptcy proceedings, where they could expect anywhere from 15 to 20 cents on the dollar.

Following Lehman's collapse, assets in ETNs plunged from $7.5 billion to $3.5 billion by the end of 2008, even as assets in ETF continued to surge.

It is unclear if the benefits of ETNs over ETFs will keep them from disappearing altogether. ETNs eliminate tracking error as their issuers don't actually have to piece together underlying securities to track an index. ETNs are also possibly more tax efficient, as they are not subject to capital gains when their indices re-balance. ETNs also track certain indices for which there is not a ready ETF equivalent, such as the iPath Dow Jones-AIG Copper Total Return Sub Index ETN (NYSEARCA:JJC).

ETF issuers, however, have made serious inroads in combating tracking error. ETN's tax efficiency status is precarious, as the IRS hasn't yet formulated how it will tax the instruments in the future. (Currency ETNs were stripped of their tax efficiency in 2007) And the booming Exchange Traded Fund market is rapidly expanding its product range . Investors can find an ETF equivalent for most anything if they look hard enough. ETF Securities offers a London-listed ETFS Copper (LON:COPA), which even has a leveraged and short version.

So with very few reasons remaining for investors to consider trusting their money to ETNs, it wouldn't be surprising if the entire market evaporated soon. Only two new ETNs have been launched this year.They may be the last.

Disclosure: None

Source: Can ETNs Survive?