Exchange-Traded Notes: The Next Big Thing?

As if things weren't confusing enough, a new type of exchange-traded product has hit the market: exchange-traded notes, or ETNs.

In most respects they act just like exchange-traded funds, or ETFs, but they have added tax advantages. They also have a few risks you won't find in ETFs.

Both ETNs and ETFs act like low-cost index funds. Their differences are under the hood. An ETF consists of a portfolio of securities (or sometimes a cache of gold or silver bullion), and owning a share gives you claim to a small portion of that portfolio. With ETNs, however, there is no portfolio. You get what is, in essence, a bond issued by the ETN's creator, Barclays. The ETN promises to repay the amount of your investment plus (or minus) the return of the index that the ETN tracks, less a management fee.

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Barclays, one of the world's biggest ETF managers, issued its first two commodity-focused ETNs, iPath SP GSCI Total Return Index (symbol GSP) and iPath Dow Jones-AIG Commodity Index Total Return (DJP), in June 2006. Since then it has issued six other ETNs (with four more due out this summer). Three track different currencies, one tracks the price of crude oil, another follows Indian stocks, and one emulates a strategy of owning Standard & Poor's 500 and selling covered-call options against the index.

If all goes well, ETNs should act much like ETFs (or better, in some ways). The trading price of ETF shares can sometimes stray from the value of the underlying portfolio. But with ETNs, that's not a problem because Barclays promises to pay exactly the index's return minus fees, which range from 0.4% yearly for currency ETNs to 0.89% for the India fund.

As for taxes, ETNs don't pay cash distributions. Instead, the value of dividends, interest and investment gains is lumped into the funds' total return. So you won't face any taxes until you sell your shares. And even then, any gains on shares held more than a year should be taxed at 15%, according to a legal opinion Barclays obtained. In contrast, 40% of gains from ETFs that hold commodities futures and 100% of gains from currency ETFs are taxed at higher, ordinary income-tax rates.

What's the downside of ETNs? The Internal Revenue Service has not weighed in on the proposed tax treatment, so some uncertainty remains. In addition, ETN investors could suffer if Barclays's ability to repay the bonds ever came into question. That's unlikely -- Barclays is one of the world's biggest financial institutions -- but you can't dismiss the prospect entirely.

Most of the indexes tracked by ETNs are also tracked by ETFs. If you are investing in a tax-deferred account, stick with ETFs for now. ETNs could well be the better option if you invest in taxable accounts, but you probably should give them more time to prove themselves before you jump in.