ETN Market Heats Up

August 03, 2007

The exchange-traded note (ETN) market is about to get much more interesting.

The exchange-traded note (ETN) market is about to get much more interesting.

Just over one year after Barclays Capital launched the first ETNs on the New York Stock Exchange (NYSE), a handful of banks are moving to copy its success.

On Tuesday, Goldman Sachs became the second bank to offer an ETN, debuting the GS Connect S&P GSCI Enhanced Commodity Total Return Strategy Index ETN (NYSE: GSC) on the New York Stock Exchange (NYSE). GSC tracks a tweaked version of the S&P GSCI, the same commodity futures index that underlies the iPath GSCI Total Return ETN (NYSE: GSP) and iShares GSCI ETF (NYSE: GSG). The new ETN from Goldman Sachs, however, uses an enhanced roll mechanism in an attempt to boost returns, much in the way that the PowerShares DB Commodity Index Tracking ETF (AMEX: DBC) does. The new ETN's roll strategy better work, too, as GSC charges 1.25% in annual fees compared to just 0.75% for competing commodity products.

The prospectus is available here.

On Thursday, the Swedish Export Credit Corporation also launched a new ETN, using Merrill Lynch and Nuveen Investments as sales agents. Under the "ELEMENTS" brand name, the new note tracks the SPECTRUM Large Cap U.S. Sector Momentum Index, a benchmark that applies a sector-focused "momentum investing" strategy that overweights hot sectors in the S&P 500 while underweighting cold ones. On a backtested basis, the SPECTRUM strategy has thumped the S&P 500; whether that outperformance will continue in the real world remains to be seen. The new ETN charges 0.75% in annual expenses, and trades under the ticker symbol EEH.

The prospectus is available here.

More ETNs are on the way: Swedish Export Corp plans to launch ETNs tied to the Rogers International Commodity Index - Energy Total Return and the Rogers International Commodity Index - Metals Total Return indexes, while Bear Stearns is getting into the act with its new BearLINX Alerian MLP Select Index ETN, The BearLINX ETN is tied to an index of energy-oriented Master Limited Partnerships (MLPs), which are high-yielding securities focused on the natural resource industry. That ETN will charge 0.85%. [The prospectuses are linked to each name above.]

What's An ETN?

ETNs are senior, unsecured debt notes linked to a given index. They function much like an exchange-traded fund (ETF): you can buy or sell them throughout the day through a brokerage account; they charge fees; and their performance typically tracks very closely to a given index.

ETNs have critical differences compared to ETFs, however. As debt notes, ETNs don't actually own anything. When you buy an ETN, the underwriting bank promises to pay you the amount reflected in the index, minus fees. If the bank goes bankrupt, ETN-holders would be out-of-luck. ETFs, for the most part), own a share in a pool of assets

ETNs have become popular with investors, however, because they convey unique advantages. First, there is no long-term tracking error: In each case, the bank agrees to pay large shareholders the exact value of the note on a weekly basis, which helps the ETNs track very closely to the underlying index return.

Their big calling card, however, is tax efficiency. ETN providers all advise that, under current tax law, ETNs should be treated as "prepaid contracts." If that's the case, the notes will never pay distributions, and shareholders will only owe taxes when they sell. If you hold an ETN for more than a year, all your gains - interest income, capital gains, etc. -- will be long-term gains, taxed at 15%.

That's a huge advantage, assuming the IRS doesn't come up with an alternate treatment. The ETNs tend to target tax inefficient categories such as commodities, currencies, and options strategies. Even the new Elements SPECTRUM ETN, while focused on stocks, pursues a tax inefficient strategy, buying and selling sectors as it chases momentum. The after-tax return in these ETN will be much stronger than it would be in a comparable ETF or mutual fund better than it would be in an ETF.

There's real debate about whether the tax treatment will hold, but for now, this is a significant advantage.

What's The Same And What's Different About The New ETNs

For the most part, this new crop of ETNs follows the same format as the Barclays products, with a few quirks.

Tracking Error

Each new ETN promises weekly redemption liquidity at NAV for large shareholders. The Bear Stearns note, however, charges a 0.125% redemption fee for the privilege. This fee will not hit individual shareholders - it only applies to large, institutional investors that exchange large numbers of notes - but it could impact tracking error by limiting the profitability of arbitraging the notes. It will pay to keep an eye on tracking error for the new BearLinx products.

Expense Ratio

One key difference between the ETNs is in the expense ratio. While the iPath ETNs all charge 0.75%, the new GS Connect ETN charges 1.25% and the BearLinx ETN will charge 0.85%. (The SPECTRUM ETN sticks with the familiar 0.75%).

Credit Worthiness

Another difference between the ETNs is the issuing bank. The credit-worthiness of the issuing bank is important for an ETN, of course, because if the bank goes bust, ETN holders are out of luck. The ratings from Moody's for the four issuers are:

Barclays Bank: Aa1
Bear Stearns: A1
Goldman Sachs: Aa3
Swedish Export Credit Corp: Aa2

Despite the official ratings, traders seem to believe that the investment banks are riskier than Moody's says. Credit default swaps on Goldman Sachs and Bear Stearns bonds have soared recently, thanks to growing concern about the mortgage market. The price for swap contracts on Bear Stearns in particular has risen, following the implosion of two Bear hedge funds in June. According to Moody's, swaps on Bear Stearns now imply a rating of Ba1 - one level below investment grade and six levels below Bear's official A1 ranking. Swaps on Goldman debt are rated Ba1. Data on the prices of Barclays and Swedish Export Credit Corp swaps were not available at this time.

Is the risk worth the benefit? That remains for each investor to decide.


It was really only a matter of time until more companies showed up to the ETN party. After all, ETNs are nothing more than structured products with lower fees, somewhat better liquidity and a better marketing platform. Barclays has done very well with its ETNs, gathering close to $3 billion in eight funds in just over a year. As every major investment bank offers structured products, it stands to reason that every major investment bank will at least consider ETNs, as they look for new ways to grow assets under management.

Shareholders should keep a close eye on credit risk, fees and the status of the tax opinion from the IRS on all of these ETNs. But given the potential advantages of the ETN structure, investors should also keep an eye on these notes as investment possibilities.

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