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TRADER'S NOTEBOOK


Consider, If You Will, The Exchange Traded Note

08/13/08 12:26:04 PM PST
by John Devcic

Here's what it is, and here's how to consider it.

You may have heard of the new investment vehicle that has become popular recently, the exchange traded note (ETN). If you have never heard of an ETN or may have heard of it but have no idea how they work, then read on; this article is for you. Here's what an ETN is and how it works, and here are some of the advantages and disadvantages about investing in ETNs. So what is an exchange traded note anyway?

WHAT IS AN ETN?
An exchange traded note is an unsecured debenture first introduced as an investment in 2006. The best way to think of an ETN is to imagine if you were to combine the best points of a bond and an exchange traded fund (ETF). An ETN is a note and not a fund that holds a basket of securities. You have to look at ETNs as a bond first and foremost, and like any other bond, ETNs have an issuer.

Here's how an ETN actually works. An issuer will create a note with the express purpose of providing you with a return based upon an index or other investment strategy of the issuers choosing. This return will be somewhere in the future, which means these notes, like bonds, have a maturity date. These notes are openly traded on an exchange much like any other security and in particular like an ETF. Most ETNs have a maturity date some 20 or 30 years into the future.

ETNs will be traded on the open market, which means the value of a particular ETN will rise and fall daily. As an example, assume you purchased an ETN at $60 and that note matures in 20 years. Let's also assume that the ETN has had a nice rise of 400% in those 20 years. You would receive $240. Note that this figure does not include any expenses or fees.

It is important to remember that an ETN will never hold any security but rather guarantee the owner of the ETN a return based upon the performance of the index or strategy it is designed to track. Of course, I should mention that if the strategy or index does not perform well, the return of the ETN will be affected as well.

ADVANTAGES OF ETNs
Access to markets and strategies: ETNs offer a fairly easy way to invest in what usually can be difficult markets for investors to get into. For example, commodity and currency ETNs are very popular. There are also ETNs that track the Indian stock market. Or if you would like to invest in a particular investment strategy like the Dogs of the Dow, you can with the "Dogs of the Dow" Dow Jones High Yield Select 10 Total Return Index created by Deutsche Bank. The Dogs of the Dow strategy may be too costly for most investors, and an ETN can step in and allow you to profit from the strategy without having to buy any shares of stock.

Liquidity: ETNs are openly traded on an exchange that allows an investor to be able to see daily what his or her ETN is worth. You can easily buy and sell ETNs without holding till maturity. Trading openly on the market allows an investor to quickly get in or out if he or she chooses to do so. This is why ETNs are often compared to ETFs. In this case, the comparison does make sense, as they are both openly traded on an exchange. Similarities between ETFs and ETNs stop there, however.

No more tracking errors: ETFs have had issues in properly tracking an index. There are many factors that can affect the ability of an ETF to track the performance of the underlying index. Some factors such as fees and expenses, redemption costs, and dividend reinvestment policy can all cause an ETF to not properly track the underlying index. These issues do not exist with ETNs because you have the issuer's guarantee to return an exact replica of the performance of the underlying index or strategy. You also have the advantage of an ETN not holding any securities so those factors that cause tracking errors in ETFs are done away with. This is why a lot of ETNs that track a commodity index are becoming popular.

DISADVANTAGES
Credit risk: The biggest risk inherent with ETNs is the credit rating of the issuer. You have the guarantee of the issuer to replicate the return of the underlying index or strategy at maturity. This guarantee is as good as the credit rating of the ETN's issuer: the more creditworthy the issuer, the better their guarantee. This is the most important part of understanding ETNs. Like bonds, you must first look at the creditworthiness of the issuer before you begin looking at a particular ETN.

Illiquidity: I know what you are saying. One of the benefits of an ETN is liquidity, so how can it also suffer from illiquidity? Illiquidity is the result of a lack of buyers and sellers, which would be the case if a new ETN does not garner enough interest.

ETNs are new and the success of any particular ETN will be decided by how much of that ETN is sold to the public. Investors, big and small, will decide the success of a particular ETN if they decide to purchase an ETN. You have to make sure that there is decent volume before you buy an ETN. If not, you may not be able to get out once you have gotten in.

TAX CONSIDERATIONS
Since the introduction of ETNs, one of their biggest benefits according to their issuers is their tax efficiency. As of right now, the Internal Revenue Service (IRS) has only made a decision on taxes regarding currency ETNs; it has not made a ruling about other ETNs, so investors should not regard an ETN as tax efficient until the IRS makes a ruling. You will still see some articles discussing the tax efficiency of ETNs, but until the IRS makes a ruling regarding taxes and ETNs, you should not assume it will be a benefit.

In December 2007, the IRS made a ruling regarding the tax implications of ETNs tracking currencies only. Those ETNs will be considered debt for tax purposes. This was to make sure that any gains in currency ETNs would be taxed the same way as any other currency investment. ETN holders will have to pay taxes on any interest earned without getting any of the money. Any interest earned is assumed back into the value of the ETN and will only be distributed when the owner of the ETN sells or the ETN reaches maturity.

ETNs are still new and only time will tell if they have a future. Right now they are being issued at a fast pace. Taking time to properly evaluate these investment vehicles is the most important step for any investor. Keeping an eye on the issuer's credit status is as important to an ETN holder as monitoring the performance of the strategy or index that ETN is tracking. You should also not assume that there will be any tax advantages to buying an ETN until the IRS makes a ruling. So keep an eye on any future tax rulings from the IRS. This, of course, has not stopped ETN issuers from touting their perceived tax benefit. Investing in ETNs has its benefits, but be wary of their disadvantages as well.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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