I was reading the new issue of Kiplingers and one of the box blurbs caught my eye. It was a short article on ETNs, Exchange Traded Notes. I had never heard of a ETN before this. Conceptually I had always thought they should exist, but had never come across them. So those of you who don’t read Kiplinger’s may be asking, “So what is an ETN exactly?” ETNs are Exchange Traded Notes. They are technically debt notes issued by Barclays (Barclays purveyor of the ubitiquous iShare ETFs are the currently the only financial institution that isssue ETNs). Like ETFs they track different indexes, but unlike ETFs they do not actually own the underlying the commodities/shares that make up that index. Barclays iPaths (it’s family name for it’s ETNs) were originally offered as another way of tracking different commodity indexes, Oil (OIL), Goldman Sachs Commodity (GSP), and Dow Jones Commodity (DJP) indexes. Barclays has subsequently expanded the iPath family to include: MSCI India Index (INP), GBP/USD (GBB), JPY/USD (JYN), EUR/USD (ERO) Foreign Exchange Indexes, and most interestingly a Buy Write S&P 500 Index (BWV).

Personally I had never heard of the S&P 500 Buy Write Index, but after a quick google I learned it’s basic concept. The index tracks a hypothetical long portfolio of the S&P 500 (the BUY part), and additionally writes (sells) 1 month calls at or slightly out of the money. There are traditional funds that do this, but the ETN structure is particularly attractive for tax reasons.

ETNs offered by Barclay’s have expense costs (between 40 and 89 basis points) that are higher than comparable iShare ETFs, but offer slightly different risks and advantages (even if they track the exact same index). ETNs because they don’t actually hold any of the products of the underlying index and as a resultnever have distributions or other taxable events such as dividends. The only profit to be made from a ETN will always be from the purchase and sale of the of the fund. All gains are capital gains. The ETN however will add the value of dividend distributions and such into the index value of the ETN. An investor in ETN does not forgo dividends, but merely has the ability to take them as a capital gain. In the case BWV, this structure is particularly advantageous. Income generated by selling calls is normally treated as ordinary income. The ETN structure allows investors to avoid income taxes on both income from written calls and dividends (especially dividends that do no qualify for the lower qualified dividend tax rate) as would take place in an ETF or traditional mutual fund. What allows an ETN to offer this tax advantage does come at a cost. Because no underlying securities are held by the ETN, the value of the ETN (as with all unsecured debt) is only secured by a promise made by Barclay’s. Barclay’s is of the high credit quality(AA and Aa1) and can be expected to make good on it’s promises, however by investing a Barclay ETN you are exposing yourself to credit risk that you would not be with an ETF. ETFs are secured by actual assets and ETNs merely by a promise. There also those who believe that the tax treatment that Barclay’s has argued for ETNs is particularly aggressive and will not hold true in the long run. If the IRS were to rule against Barclay’s interpretation of the law it would possible for investors to owe back taxes after the fact.

Personally I think can ETNs can make an interesting addition to a portfolio as long as the risks (credit and tax uncertainty) are considered. Given that I’m not much for commodity or foreign exchange investing, the India and Buy Write ETN look the most interesting to me. The Buy Write especially so because it executes on a strategy that would be much more expensive either because of taxes and/or transaction costs to implement otherwise.