Same Strategy, Different Wrapper

Those who follow the exchange-traded fund industry are well aware of the ETN structure's fall from grace during the ongoing global financial crisis. With once-venerable financial institutions collapsing left and right, we certainly understand why investors want to avoid the credit risk inherent with ETNs. After all, why would any (sane) investor take on additional credit risk during a global financial meltdown if there are suitable alternatives available?

Unfortunately, there isn't always an ETF that offers the same market exposure. This is attributable to the structure of the funds and the regulatory acts that govern the exchange-traded fund industry. Whereas ETFs are subject to the Investment Company Act of 1940, ETNs fall under the Securities Act of 1933. The major point here for investors trying to differentiate between ETFs and ETNs is that, with an ETF, the investor has a claim on the basket of securities held by the fund. ETN investors are promised the return of a given index but do not have any claims on the assets that constitute the index. This makes ETNs the structure of choice for difficult-to-access markets, less-liquid securities, and the construction of sophisticated asset-allocation strategies. For more info on the nitty-gritty of ETNs, please see our recent article, "ETNs Demystified."

Until today, the most notable use for ETNs was to gain commodity exposure. Remember, commodity funds typically provide exposure to commodity futures and options (which normally must be "rolled" from month-to-month), not the actual commodities themselves.

Barclays'  iPath Dow Jones-AIG Commodity Index (DJP), which launched in 1996, was previously the most popular exchange-traded product for gaining exposure to commodities. Since September, however, the fund has seen about $1 billion in assets flee for the exits. Over the same period,  PowerShares DB Commodity Index Tracking Fund (DBC) (which is structured as a limited partnership and lacks the credit risk of ETNs) has attracted nearly $300 million in assets. This is an example of investors voting with their dollars.

For several months now, we've been recommending  ELEMENTS S&P CTI ETN  as a portfolio diversifier and an effective way to gain commodity exposure. Long-short strategies in the commodity complex have a solid theoretical base, in our view. Testing this strategy over the past 20 years, it has shown slightly higher returns than traditional long-only commodity indexes while having substantially lower volatility. To learn more about this interesting ETN's strategy and get our take, please see my colleague Bradley Kay's recent article, "A Hedge Fund for Cheap."

Investors who were intrigued by this successful strategy but took pass on our recommendation in order to avoid the ETN credit risk will be pleased to learn that the same strategy is coming to the ETF structure. On March 23, Claymore Securities filed its preliminary registration statements for Claymore/S&P Commodity Trends Indicator ETF, which is based on the very same index as LSC. The fund is slated to trade under the ticker CTI. The expense ratio and some other details have yet to be ironed out, but stay tuned and we'll keep you posted on this development.

There is a trade-off to consider though. To avoid the inherent credit risk of ETNs but maintain a similar return profile, investors must be willing to accept a less tax-efficient structure that can produce slight tracking errors. Commodity ETNs only incur a taxable event when an investor sells his or her shares. If held for longer than a year, any gains would be taxed as long-term capital gains, and shares held for less than a year would be treated as ordinary income. Holders of ETFs, like DBC, on the other hand, will be slapped with a tax bill each year (via a schedule K-1) regardless of whether or not the fund is sold. For an in-depth explanation of the nuances of taxation for ETFs, please read my colleague Paul Justice's recent article, "Your ETF Tax Questions Answered."

The strategy of launching an ETF for a strategy (or index) that is already available in the ETN wrapper makes a lot of sense to us. In fact, we expect more ETF providers to follow suit. The most obvious case would be for  Barclays (BCS) to launch the DJP as an ETF and attempt to recoup some of its lost assets. However, with its iShares franchise on the auction block, there may be more pressing issues to deal with at Barclays. We'll be following this trend closely over the next several months. As always, when deciding between an ETF and an ETN, investors should look at their own objectives and risk tolerances when weighing the trade-off of credit risk versus tracking error and tax efficiency.

In full disclosure, we currently own ELEMENTS S&P CTI ETN in our Hands-Free Portfolio--a model portfolio that is available to Morningstar ETFInvestor subscribers (see the links below for more details).

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