Exchange Traded Notes: Are the Benefits Worth the Risk?

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Includes: DBC, DJP, GSG
by: IndexUniverse

By Matthew Hougan

The discussion on IndexUniverse.eu of the swooning prices of Barclays Capital and other banks has me wondering: Would you own an exchange-traded note?

It's a question I've received from a number of advisors recently, particularly late last week, as the share price of the leading ETN issuer Barclays PLC tumbled headlong toward zero. Those questions have abated now that Barclays' share price has stabilized—and may abate more given Barclays' announcement today that it earned $7.5 billion in 2008 while writing down nearly $12 billion in bad debt. But as you say, there's no guarantee we've seen the worst of things yet in the Financials space.

The risk in holding an ETN, of course, is that some weekend we will wake up to learn that the underwriting bank has been nationalized and its senior debt holders wiped out. This seems extraordinarily unlikely for a bank as large as Barclays—especially for one that is profitable right now—but it is a question in this extraordinary environment.

Currently, a small minority of note holders are voting with their feet. Assets in the iPath DJ AIG Commodity Index Total Return ETN (NYSEArca: DJP) are down about 18% ($225 million) year-to-date, while the fund itself is down just 3.6%, suggesting some withdrawals. Still, there is more than $1.2 billion invested in the note, and it remains the largest broad-based, exchange-traded commodity product in the world... ETF or ETN.

The thing that gets overlooked about ETNs in the commodity markets is that they have real advantages over ETFs: namely, zero tracking error and superior tax treatment.

On taxes, commodity futures ETFs like the PowerShares DB Commodity Index Fund (NYSEArca: DBC) are taxed as 1256 contracts. That means any gains you make in the funds are taxed annually, whether or not you sell the fund; there is no way to defer capital gains. Moreover, those gains are taxed 60% as long-term gains and 40% as short-term gains, creating a maximum blended tax rate of 23%. Commodity ETNs, by contrast, are taxed like traditional equities: No taxes are due until you sell the note, and gains on ETNs held for more than a year are taxed as long-term capital gains, at 15%. That can be a big difference for longtime holders.

This superior tax treatment is theoretically under review at the Internal Revenue Service, but the IRS has taken no action on the matter since a flurry of activity more than a year ago. It seems likely to me that the IRS has simply exercised a pocket veto, refusing to rule on the matter and therefore letting the status quo persist.

Tracking error is a topic that gets overlooked, but it can be significant in the commodity space. Tracking a commodity index, with its monthly contract rolls and other factors, is hard—much harder than tracking a broad-based equity index. The iShares S&P GSCI Commodity Index Fund (NYSEArca: GSG), to take one example, missed its benchmark by 0.98% in 2008. Admittedly, it outperformed the index—tracking error in commodity funds tends to dampen returns, and GSG's index crashed in 2008—but chances are the fund will lag a bit on the upside as well. With an ETN, you are assured 100% of the index return, eliminating tracking risk.

Still, there's no avoiding the elephant in the room: ETNs are credit notes, and there is a chance in today's environment that you will wake up and find that the banks have been nationalized and unsubordinated debt (which is what ETNs are) has been wiped out.

The ETN providers have done everything they can to mitigate this risk: They allow daily redemptions, for instance, so you can exit the fund at net asset value in a one-day window. But there's nothing they can do to change the nature of what ETNs are.

So that's the question to you: Would you own an ETN in the current environment? Are the benefits—particularly in the commodity space—worth that risk?