Assets Pour Into a Curious and Controversial Investment

Photographer: John Lund/Getty Images

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Photographer: John Lund/Getty Images

A quick poll of friends reveals that they, like most investors, have no idea what ETN stands for. Among the guesses: European Treasury Note, Equal to None, and Et Tu, Nero? Two personal favorites: Elephant Tracking Node and Extra-Terrestrial Novice.

Closer to reality: Explore the Nuances.

ETNs are exchange-traded notes, cousin of the far better-known exchange-traded fund, or ETF, and they have been at the center of some drama lately. Despite a drop in new launches and critical articles in the financial news media, ETNs are growing at twice the rate of ETFs -- and not many things have grown faster than ETFs, except maybe the Internet. Total ETN assets jumped 47 percent, or $8 billion, over the past 12 months, to $25 billion, compared to about 25 percent for ETFs.

What makes all this so curious is that almost everything ETNs track you can get in an ETF, with less risk. So why on earth have these things captured $25 billion in assets, much less $25?

The answer lies largely in their tax treatment, which appeals to income-oriented investors.

What Are They?

Like ETFs, ETNs trade on an exchange, track an index and provide real-time, intra-day updates on the underlying value of the product (think of that as the fair value for the ETN at any given moment in time). Unlike ETFs, they don’t hold an underlying basket of securities or futures contracts. Instead, they’re unsecured debt obligations from a bank or other financial institution and promise to match the performance of a certain index over a specified period. If the issuer defaults, investors could be wiped out. Lehman Brothers had a couple of ETNs. It’s unclear whether investors, which were mercifully few, got their money back.

Most of the assets in ETNs are clustered in a few areas:

Master-Limited Partnerships

ETNs that track master-limited partnerships (MLPs) make up 42 percent of total ETN assets, the largest segment of the group. The key word here is partnership. MLPs aren't taxed like normal corporations as long as they pass on income to holders. It's an efficient way to hold assets that produce income on a regular basis, like oil and gas pipelines. However, investing in them is a gigantic mess and a game of picking your poison.

The reason MLPs are such a big chunk of ETN assets is that a registered investment company cannot hold more than 25 percent of its portfolio in MLPs. This is why MLP ETFs are structured as C corporations instead, and so have to pay a 35 percent corporate tax. That takes a huge bite out of returns and makes it hard for ETFs to track an MLP index. ETNs avoid this corporate tax because they’re structured as debt obligations and don’t have to actually hold the underlying MLPs.

The Alerian MLP ETF (AMLP) is a good example of how far these ETFs can veer from the return of the index they're trying to track. AMLP has returned 46 percent since its inception in August 2010. Sounds good. But its index is up 85 percent. Apologies in advance for the acronyms, but compare that to the UBS ETRACS Alerian MLP Infrastructure ETN (MLPI). It tracks the same index as AMLP but has returned 78 percent. This is why MLPI has grown from $800 million to $1.8 billion in the past year.

The ETN structure doesn’t get a free pass on this tax issue. Income distributions from ETNs are taxed as ordinary income, since they're considered interest payments. Issuers takes their expense ratio out of the income to minimize what investors get taxed on, which is why ETNs in this area yield a bit less than ETFs. In general, the ETN is used by investors more interested in a higher total return; investors who are more interested in the income or who don’t want to take on credit risk use the ETF.

Commodities

Commodity ETNs have $6 billion in assets and make up about 25 percent of the ETN pot. The largest commodity ETN is the $1.6 billion iPath Dow Jones-UBS Commodity ETN (DJP), which tracks 10 commodities. These ETNs offer a tax advantage as well, albeit a different one from the MLP variety. The benefit here is that the ETN is taxed normally -- taxed only when you sell shares. So it is taxed at 20 percent if you sell after one year and at 39 percent if you sell within one year.

Compare that to commodity ETFs. They must physically hold futures contracts, which changes their tax treatment. It leads to 60 percent of gains being taxed at a 20 percent rate, and the remaining 40 percent at the investor's ordinary income rate. Assuming a 39 percent rate, the maximum blended tax rate is 28 percent. This tax is applied to gains each year, regardless of whether shares are sold or not. If that isn't enough hassle, commodity ETF investors get an additional tax form called a K-1.

ETNs also track many smaller commodities you can’t get in ETF form. One example is the iPath Dow Jones-UBS Coffee Subindex Total Return ETN (JO), which tracks coffee futures. It has returned 96 percent so far this year and is the overall best performer of all ETFs and ETNs.

So between MLPs and commodities, about two-thirds of ETN assets appeal to investors who are looking to get better tax treatment and have decided the credit risk is worth it.

Custom-Made Products

Custom-tailored ETNs, designed and launched with one investor in mind, account for about $3.4 billion of the total, or 13 percent. These products are the fastest-growing area in the ETN world and got about half of that $8 billion 12-month asset growth. One example is the Barclays ETN+ FI Enhanced Global High Yield ETN (FIGY). It provides leveraged exposure to the MSCI World High Dividend Yield Index. It was created for Fisher Investments, which worked with Barclays to construct it so that it would fill specific investment needs for the firm's clients. Fisher Investments accounts for 97 percent of the $1.5 billion in this particular ETN.

The High-Octane Stuff

ETNs built around volatility indexes are the most hard-core of the hard-core, and a big reason ETNs get a bad rap. These ETNs account for 10 percent of total ETN assets and asset growth was flat over the past 12 months. However, they account for 75 percent of ETN trading volume. These things mostly lose money over the long term, but traders love them for fast, liquid and convenient exposure to different variations of volatility.

An example of what can go wrong here is the VelocityShares Daily 2x VIX Short-Term ETN (TVIX). The Chicago Board Options Exchange Volatility Index, known as the VIX, is a gauge of U.S. stock volatility. The VelocityShares ETF returns two times the daily return of the VIX futures contracts. TVIX is a combination of three things individual investors should stay away from: VIX, the futures market and leverage. Not only that, but TVIX once stopped issuing new shares for a short period, which caused its price to become wildly unhinged from its underlying net asset value. Some retail investors lost large chunks of money.

Bottom Line

Individual investors should approach ETNs with caution. Put another way: Extra Thought Necessary.

More stories by Eric Balchunas:

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Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here, and weekly ETF podcasts can be found here.

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