When it comes to exchange-traded funds and their less-well-known siblings, exchange-traded notes, few recognize their very different investment and tax characteristics. Even fairly sophisticated investors aren't sure if they own one or the other.

Yet there are important differences between the two investments. Like exchange-traded funds, exchange-traded notes, or ETNs, are designed to track a particular index. But while the 84 ETNs now available trade on stock exchanges, they are really unsecured promissory notes issued by banks such as Barclays, Deutsche Bank and UBS AG. This investment status is not always apparent, since the names attached to the ETNs, such as iPath, PowerShares and Elements, differ from those of the issuer responsible for paying off the note.

While ETNs have maturity dates, most investors buy and sell them on the secondary market at prices pegged to changes in their relevant indexes, minus fees. Exchange-traded funds, by contrast, represent an ownership interest. Because their assets can't be touched in bankruptcy proceedings, they provide some degree of protection to investors in case the issuer goes belly-up.

Few people paid attention to these differences between ETFs and ETNs or recognized the debt character of exchange-traded notes until the September 2008 bankruptcy of Lehman Brothers, which delivered an unexpected surprise to investors in three ETNs. Because the ETNs were unsecured debt instruments, these investors weren't protected and they had to wait in line with other creditors hoping to recoup at least some of their investment. Lehman's bankruptcy, along with a downturn in the commodities markets behind the bulk of ETN investments, sent assets in exchange-traded notes plummeting from $7.4 billion in June to $3.7 billion in November.

Now, however, with a rebound in commodity prices and restored confidence in the credit markets, assets in exchange-traded notes are once again on the rise, and further expansion appears likely as investors seek an easy way to tap into the commodities markets or hedge against inflation. According to the SPDR 2009 midyear ETF review of both ETFs and ETNs, commodity products accounted for 53% of the industry net inflows during the first half of 2009. Although more than one-half of that total is attributable to SPDR Gold Shares (GLD), an exchange-traded fund backed by physical stores of a precious metal, exchange-traded notes experienced strong activity as well.

Renewed confidence in ETNs is coming from investors like Ron Rowland, the president of Capital Cities Asset Management in Austin, Texas. Rowland abandoned exchange-traded notes last year after the Lehman disaster. But now, however, when there's less risk in the credit markets and the stocks of major issuers are recovering, Rowland says he feels more comfortable investing in them, at least if they come from the major issuers.

Still, he sees room for improvement in these offerings. "I think it would be great if the industry made ETNs secured obligations," he says. "For every ETN share that is created, why not escrow the money received against the bonds being issued? They could even be invested in U.S. Treasury securities if sponsors really want investors to feel better about these products."

Alternatively, sponsors could establish ETNs as separate entities, making them more like ETFs, or have the ETNs insured by a third party.
It's unclear whether credit risk will affect the ETN market in the future or most investors will even care. Martin Kremenstein, a director at Deutsche Bank overseeing both U.S. exchange-traded funds and ETNs, says advisors he speaks with are generally comfortable with the credit aspect of ETNs, or else they are short-term traders who don't hang on long enough to be concerned. He doubts that giving ETNs stronger protection through bond insurance would give investors confidence considering their concerns about bond insurers. "We did look into collateralizing ETNs at one point but found that the IRS would then consider them as funds, and that would essentially eliminate their tax benefits," he says.

The problem, of course, is that such solutions would cost more, and those costs would then likely be passed on to investors. For now, those investors will have to rely on an issuer's creditworthiness for its ability to pay its obligations.

Barclays, which stands behind the suite of iPath exchange-traded notes, and Deutsche Bank, responsible for PowerShares ETNs, are by far the largest issuers of ETNs in terms of assets. (Others are listed in the accompanying chart.) While rating agencies consider them financially solid, the Lehman bankruptcy and the plunge in bank stocks last year offer stark reminders that even the most creditworthy financial institutions carry some risk.

Another sticking point for both ETNs and ETFs that track commodities is that the Commodity Futures Trading Commission (CFTC) is looking at imposing position limits in U.S. futures markets to curb speculation. Such limits, already in effect for certain agricultural commodities, could distort market prices if the ETFs and ETNs that use futures contracts were forced to limit the number of outstanding shares.

Tax treatment is one area where the ETNs have a clear advantage. Exchange-traded funds such as SPDR Gold Shares (GLD) and the iShares Silver Trust (SLV), which hold stores of precious metals in secure vaults, are structured as grantor trusts and treated as collectibles by the IRS for tax purposes. So any capital gains you make when you sell are taxed at a maximum rate of 28%, no matter how long you hold the ETF. During the holding period, the trust may also generate taxable gains from bullion sales used to pay operating expenses.

Those ETFs that use futures contracts, such as the iShares S&P GSCI Commodity Indexed Trust, are treated somewhat differently. Under IRS regulations, any annual income and profits they generate are taxable and reported on a Schedule K-1. Sixty percent of the gains are taxed as long-term and 40% as short-term.

The tax treatment of ETNs is much less complicated and more favorable, at least for now. Although the IRS has not come out with a formal ruling on tax treatment, ETN issuers argue that they are essentially prepaid contracts and subject only to ordinary capital gain or loss tax rates when they are sold.

The favorable tax treatment of ETNs came into question in 2007 when the IRS ruled that gains and losses associated with the sale of ETNs linked to a single currency are taxed at ordinary rates. Though the ruling did not extend to all ETNs, the IRS could easily change its mind in the future.

Another advantage ETNs have is their ability to track their indexes more efficiently than many ETFs, whose underlying investments in futures contracts make it difficult for them to precisely follow commodity indexes. The exchange-traded notes are simply designed to provide index returns, minus expenses.

Of course, precise tracking is a double-edged sword. When year-to-date results were recently tracked over one period, the iShares S&P GSCI Commodity Indexed Trust (GSG), an ETF, was a few percentage points behind both its benchmark and behind an ETN based on the same index, the iPath S&P GSCI Total Return Index. But over the one-year period, the tracking-challenged ETF held a performance edge over both the index and the ETN.

ETN Choices
A number of options are available to those who find the tracking and tax characteristics of ETNs appealing. Of approximately $6 billion in ETN assets at the end of June, $4.6 billion were attributable to commodity-related products representing both single commodity sectors as well as broader, diversified baskets.

Two popular options among the diversified group are the iPath GSCI Total Return Index and the iPath Dow Jones-UBS Commodity Index Total Return (DJP). The latter ETN covers 19 commodities segregated into energy (39%), agriculture (29%), industrial metals (21%), precious metals (12%) and livestock (7%). "This broad diversification serves to both lower the ETN's relative volatility and increase its risk-adjusted returns compared with owning a small sampling of handpicked commodities," says Morningstar analyst Paul Justice. He views the fund as a core holding that could represent 4% to 10% of an investor's portfolio assets. The iPath GSCI exchange-traded note focuses more on energy (66%), followed by agriculture (18%), industrial metals (7%), livestock (6%) and precious metals (4%).

For a different approach, the Elements S&P Commodity Trends Indicator ETN (LSC) invests long on commodities that are trending up in price and it shorts those that are moving down. Its ability to do the latter gave it a significant performance edge last year when commodities crashed. It is issued by HSBC, Europe's largest bank by market capitalization. PowerShares has a lineup of ETNs that cover either the long and short side in areas such as agriculture, base metals, oil, gold and broader commodities. Many of them are leveraged, creating double long or short exposure and, of course, ramped up volatility.

Beyond commodities, the iPath MSCI India Index ETN (INP) follows the MSCI India Total Return Index and allows investors to participate in that market for a yearly fee of 89 basis points. Barclays also has four currency exchange-traded notes whose value is pegged to changes in the exchange rates between two currencies.