Seeking Alpha
Profile| Send Message|
( followers)

By Matt Hougan

Exchange-traded notes are like the forgotten stepchildren of the ETF industry: unloved and overlooked. Investors (particularly taxable investors) are missing out.

According to the National Stock Exchange, U.S. ETNs had $6.9 billion in assets at the end of September. ETFs were literally 100 times more prevalent, with $697 billion in assets. That included $62 billion just in long commodity ETFs.

That’s just crazy. And it highlights investors’ irrational fear of the ETN product structure.

I remember when ETNs first came to market in 2006: Investors couldn’t get enough of them. Barclays Capital launched the iPath Dow Jones-UBS Commodity Index ETN (NYSE: DJP) and it quickly gathered assets.

The reason was simple: ETNs offered two huge advantages over commodity ETFs.

First, they promised perfect tracking. If you bought an ETN, you would receive the full return of the benchmark, minus the fund’s expenses. Period. That’s handy, since commodity ETFs have been more prone to tracking error than most equity funds.

But the real advantage of commodity ETNs was (and remains) their tax treatment. The prospectus said (and still says) that ETNs can be treated basically like zero-dividend stocks for tax purposes. If you hold a commodity ETN for longer than a year, you only pay 15 percent long-term capital gains taxes when you sell. What’s more, you don’t have to pay any taxes until you sell.

By comparison, futures-based commodity ETFs like the PowerShares DB Commodity ETF (NYSE: DBC) are treated like futures by the IRS. That means that gains are marked-to-market each year, and investors must pay taxes on those gains at a blended 60 percent/40 percent long-term/short-term capital gains tax rate. For a high-earning investor, that puts the blended tax rate at 23 percent, payable every year.

That’s a huge difference. An ETN investor pays a 15 percent tax rate, deferrable until the ETN is sold; the ETF investor pays a 23 percent tax rate, due annually.

Risk Factor

Why don’t we see more assets flow into ETNs? The only possible reason (short of simple ignorance) is the credit risk.

The N in ETN stands for note, and that’s what they are: unsecured debt notes. Like any other uninsured promise-to-pay, their entire value depends on the credit of the issuing bank. If you buy a Deutsche Bank ETN and Deutsche Bank goes bankrupt, you lose all your money.

It’s not a theoretical fear. The very few people who held the three Lehman Brothers ETNs to the bitter end lost their money when the firm went bankrupt. It’s obvious, looking at the numbers, that the credit crisis stopped the growth of ETNs in their tracks.

But let’s be honest: For an investor who is paying attention, the likelihood of losing money in an ETN is vanishingly small. Most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.

So ask yourself: How likely is it that Barclays Capital or Deutsche Bank, or whomever is underwriting a particular ETN, will go bankrupt with less than 48 hours’ warning? Or to put a margin of safety on it, how likely is it that they will go bankrupt in the next week?

The answer right now is: not very.

For taxable investors who pay attention to the market, read the newspaper, monitor stock quotes, etc., the likelihood of being caught out on an ETN is tiny. Meanwhile, the risk of overpaying the IRS if you buy and hold a commodity ETF is 100 percent.

ETNs don’t make sense for all investors. In nontaxable accounts, I actually prefer ETFs. If you want a truly fire-and-forget investment, where you can walk away for a year or two, ETFs are the way to go. But for taxable investors who pay close attention to their accounts, there’s a lot to be said for the ETN structure.

(One caveat here: There is a risk that the CFTC’s plan to enact new regulations in the commodities market will force some ETNs to shut down. If that happens, investors would get their money back, but they could be hit with short-term capital gains if they’ve held a note for less than a year. It’s tough to gauge how large a risk this is, but it’s legitimate.)

Original post

Source: I Heart ETNs