ETNs Thrive Despite Mutual Fund Tantrums

By Brad Zigler

The mutual fund industry has been throwing a tantrum lately, but it definitely doesn’t want to take its ball and go home.

Fund purveyors have been dogged for years by the ever-growing popularity of low-cost exchange-traded products, but when Barclays Global Investors introduced exchange-traded notes [ETNs] last year, the $13 trillion industry called across the schoolyard for Congress and the Treasury Department to protect it from the big, bad bully.

ETNs are cut in consumer-sized swaths from the same cloth as the structured products institutions have been creating and trading for years. The marketing of these senior, unsecured zero-coupon debt obligations has stepped up mightily in the past few months, giving rise to a crop of commodity exposures ranging from broad (GSP, DJP, RJI) to narrow (JJG, JJN, JJC) and several in between.

ETNs are still small potatoes, asset-wise, but the institutional memory of how ETNs’ predecessors, exchange-traded funds [ETFs], are stealing the mutual fund lunch is still fresh. ETNs could be a bigger threat. A REALLY bigger threat.

Much of the notes’ attractiveness stems from their inherent tax efficiency. While ETFs based upon commodity indexes have to pass through the complicated tax structure of their underlying futures, commodity ETNs, as debt instruments, keep things real simple. No tax consequence befalls the noteholder until the security is liquidated or matures. Taxes during the holding period? Zip. Nada. Bupkis. That beats the heck out of the tax treatment of mutual funds, too, which distribute income and capital gains.

The ETN tax break is such a powerful attractant the Sidley Austin tax lawyer Alex Gelinas quipped that the notes are becoming “derivatives for the masses.”

And THAT scares the pants off the mutual fund guys. The Investment Company Institute [ICI], an industry trade group, called on Congress and the Internal Revenue Service to step in and mitigate the “unwarranted, unintended and unfair” tax advantage enjoyed by ETNs.

Now, I can see how the ICI pitched this to Congress. Capital invested in ETNs isn’t likely to be taxed as heavily as money sunk in mutual funds. Less tax revenue, fewer government spending options. Very patriotic of the ICI.

But “unwarranted?” “Unfair?”

The ICI is, naturally, self-interested. It is, after all, a lobbying group for mutual funds. Vanguard, Fidelity, American Funds and many others are represented by ICI.

But who’s looking out for investors seeking clean index exposures with minimal costs and tax headaches? Not ICI, that’s for sure.

Asking for government assistance casts ICI oddly as a schoolyard heavyweight beset by a scrawny first-grader. And as a collection of troglodytes. Innovation is the lifeblood of the financial services industry. Investors want vehicles like ETNs. The less friction generated by fees and taxes, the closer investors get to the index return.

Oddly enough, it was a product of innovation that propelled Vanguard to regain its place as the top-selling fund company in the U.S. A doubling of ETF sales by the Malvern, Pa., fund giant allowed it to slip past rival American Funds last year. Vanguard, once a vocal opponent of ETFs, has apparently seen the exchange-traded light. At least to a degree.

All of which leads me to believe that if government intervention doesn’t put the kibosh on the ETN threat, fund companies like Vanguard some day just might join the little kids’ gang.