New Exchange-Traded Notes Are No Gimmick

Many of the so-called new ideas pitched in the last couple of years by exchange-traded fund families actually are old notions dusted off and repackaged as ETFs. For every ETF that tracks a fundamentally weighted or heretofore inaccessible asset class, there are several more sector and industry funds; slicing the stock market into ever-narrower segments is not the most imaginative investment strategy.

So, it's noteworthy when an ETF purveyor comes up with a truly innovative idea. Barclays Global Investors' (BGI) new iPath exchange-traded notes are among those envelope-pushing concepts worth examining. It's a debt security that can be bought, sold, and shorted like a stock and can be used to track otherwise hard-to-get-at asset classes, such as commodities and some types of bonds.

The first two iPath ETNs track commodity indexes, though Barclays is sure to roll out more ETNs tracking other benchmarks and asset classes. There still are a lot of questions about how these securities, which have been trading for about a month, will behave and be taxed over the long term, but here's an early read on them.

Familiar Features
ETNs are not funds, but 30-year debt securities. Nevertheless ETF investors will recognize many of the notes' features. They track indexes, and investors can buy and sell them on the New York Stock Exchange through a broker at market prices that are set throughout the day by supply and demand. They also have an arbitrage mechanism that theoretically should keep their market prices close to the intrinsic value of their benchmarks. Large institutional investors who can amass 50,000 notes can redeem them directly back to Barclays once per week (usually Thursday). The bank says that should give them the opportunity to take advantage of any premiums or discounts.

The first two ETNs, iPath GSCI Total Return Index  and iPath Dow Jones-AIG Commodity Index Total Return (DJP), also aren't hard to grasp. They offer exposure to broad commodities benchmarks--respectively the Goldman Sachs Commodity Index and the Dow Jones AIG Commodity Index. The GSCI includes 24 commodities weighted by their production value. Meanwhile, the Dow Jones AIG bogy tracks 19 products ranked both by their liquidity and their production value. The Dow Jones AIG benchmark also caps the weights of individual commodities and commodity groups so nothing dominates the benchmark. That makes it more appealing from a diversification standpoint. For instance, the Dow Jones AIG has a 33% cap on its assets in energy (mostly oil and natural gas), while the GSCI has roughly 75% of its money there. Not surprisingly, Barclays says the Dow Jones AIG iPath has been the more popular of the two so far.

Expenses and Taxes
ETF investors used to low expense ratios will like the price tag. Note holders pay a 0.75% annual fee, which makes ETNs more expensive than most ETFs, but cheaper than conventional commodity funds, such as PIMCO Commodity Real Return , which charges 1.25%, and the only other broad-based commodity ETF currently on the market, Deutsche Bank Commodity Index (DBC), which estimates expenses at 1.30%.

Finally ETNs, like their ETF cousins, potentially offer big tax advantages because they don't make income or capital gains distributions. We say potential tax advantages because the rules here are not entirely clear. Barclays says investors have to pay capital gains taxes only when they sell their notes in the secondary market or accept payment when the securities mature. The firm, however, admits that the Internal Revenue Service has never actually opined on how this kind of structured product should be taxed. Indeed, the ETNs' prospectuses concede their federal tax consequences are uncertain and acknowledge the IRS could rule ETNs need to be taxed differently. It's not that far fetched that the IRS would do so. In December 2005, the IRS banned commodity funds from using a special derivative contract called a swap, which sent funds like PIMCO Commodity Real Return scrambling to find alternate ways of tracking their asset classes.

If Barclays' interpretation is right (and the bank's lawyers are confident they are), though, it would give ETNs a huge advantage over traditional funds and ETFs, such as Deutsche Bank Commodity Index, that use futures to track commodities. Forty percent of the capital gains those offerings realize when they roll over their futures contracts are subject to the higher short-term capital gains rate.

Investing on a Promise
It's clear ETNs are quite a different animal. They aren't open-end mutual funds like most ETFs, but senior unsecured debt issued by Barclays Bank PLC, a sister company of BGI. When you buy an ETF or traditional mutual fund you get a share of the stocks, bonds, derivatives, or cash in the underlying portfolio. When you buy an ETN you get a promise that Barclays will pay you what you would have gained or lost if you invested directly in the index the ETN tracks (minus commission costs and the ETNs' fees). You can take your payoff at the end of your holding period by selling your notes in the secondary market or hanging on until the security matures, which in the case of the first two ETNs is 2036.

The structure shields investors from tracking error, or the difference between the return of an index fund and those of its index. When Barclays creates a bunch of ETNs and sells them, it takes the proceeds and gives them to another subsidiary--investment bank Barclays Capital--which puts the money to work hedging the bank's obligations to pay off ETN owners. Barclays Capital can do this by buying and selling futures or other derivatives that track the commodities in the indexes, or by doing the same with the actual products themselves. Ideally, Barclays Capital will succeed in capturing the return (and possibly more) of the indexes. Whether it does or not, though, the bank has a contractual obligation to pay investors the return of the index net of fees.

Credit Risk
In exchange for close tracking, however, investors take on credit risk. There are no specific assets backing the ETNs, which seems scarier than it is because Barclays Bank has a solid credit rating (AA or "very strong" from Standard & Poor's and Aa1 or "very low credit risk" from Moody's). No company is too big to fail (a single rogue trader in Singapore brought down the venerable Barings Bank in 1995), but Barclays, which has $1.5 trillion in assets and a 300-year history, qualifies as a high-quality issuer. Furthermore, even if Barclays were to go bankrupt, when all of the bank's creditors line up in court to stake their claims, the ETNs would move to the head of the queue because of their senior status.

Eyeing ETNs
There are still a lot of questions about ETNs. The possibility of an adverse IRS ruling or a default, while remote, might keep some investors up at night. Furthermore, the iPath notes don't have much of a track record so it's difficult to tell how closely their market prices will stick to their index values. The premiums and discounts of ETFs tend to be narrow because large institutional investors who create and redeem shares in-kind directly with the fund can jump on arbitrage opportunities as they appear throughout the day. It remains to be seen if ETNs' arbitrage mechanism, which allows only for weekly institutional-sized redemptions, will be as efficient at minimizing premiums and discounts. It's hard to feel completely comfortable with ETNs before seeing them in action in the real world for a while. Nevertheless, for long-term investors seeking commodity exposure, these newfangled vehicles could prove to be viable options.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.