Corporate & Securities Law

Investors need to avoid exchange-traded notes according to columnist John Waggoner of USA Today.  It's good advice. 

Wall Street has created a new generation of investments, called exchange-traded notes, or ETNs, and they go by names such as BOXES, LUNARS, MITTS, PERQS and PISTONS.  "Except for the plainest of plain-vanilla ETNs," Waggoner advises that investors should "handle them like XPLOSIVs."

"ETNs are a relatively new development.  The value of an ETN depends on the movements of a stock index or, sometimes, even an indiviudal stock.  And, as you might have guessed," according to Waggoner, "ETNs trade on the stock exchange - typically, the American Stock Exchange."

"In those respects, ETNs are fairly similar to their cousins, exchange-traded funds.  But ETNs have a big difference:  They are debt securities, not equity securities.  When you buy an exchange-traded fund, you're buying a slice of a diversified portfolio of stocks.  When you buy an ETN, you're buying a promise - specifically, the promise that the issuer will pay the note according to the terms laid out in the ETN's prospectus."

"Those terms can be simple or complex," according to Waggoner.  "Let's start with a simple one," he suggests:  The iPath Dow Jones-AIG Commodity Index Total Return ETN.  This trades under the ticker DJP.  "The note pays no interest, but the issuer, Barclays, will pay a cash payment at maturity equal to the gain on the Dow Jones-AIG Commodity Index total return.  The maturity date is June 12, 2036.  You can sell the note before it matures, at which point you'll get whatever other investors feel it's worth."  As of last week, its value was up 9.2% in 2008.

"Jeffrey Ptak, Morningstar's director of ETF research, likes DJP because it does a better job tracking the index than an ETF can.  A fund has to use futures and other investments to track the commodity index.  Because a note isn't a fund, it doesn't have to line up investments that mirror the index.  All it needs is the promise to pay according to the index's movements. 

As a way to get broad exposure to commodities, Ptak says, DJP isn't bad.  The index the note uses is well-diversified, and the overall cost to investors is decent.  However, the more complex ETNs can be complex indeed.  Consider the Capital Protected Notes based on the Morgan Stanley Capital International Europe, Austral-asia and Far East stock index.  The notes trade under the ticker EEC." 

According to Waggoner, "Here's the deal:  Like DJP, EEC pays no interest over its term, which began May 23, 2005.  Each note was issued at $10.  When the note matures on December 30, 2008, the underwriters will pay note holders $10 per note. This is where the 'capital protected' part comes in: If you hang on to the note, you'll get your money back." 

The trade-off is that you give up some of the potential capital gains from the EAFE index in return for the capital protection.  "In this case, you give up quite a bit.  The note takes the index level at four different dates and averages them together.  The percentage difference between the average of the four dates and the starting date is your return.  In a rising market, your gains from this ETN will be considerably lower than if you had simply bought an ETF that tracked the index.  (The average will be smaller than the differnce between the start and the end point.)  Given this snakebit market, you might think that the smaller returns are a good trade for preserving your capital.  Should the market soar, however, you'll probably feel considerable buyer's remorse."

According to Waggoner, ETNs have a few other considerations:

First, counterparty risk.  "An ETN is backed by a promise.  Although the issuers of these notes are large, financially strong firms, you should be aware that, at least until recently, everyone thought that investment back Bear Stearns was financially strong, too."

Second, tax risk.  "The IRS is reviewing the tax treatment of ETNs and may consider taxing ETN profits as interest, rather than at lower capital gains rates.  Already, the IRS has ruled that single-currency ETNs will be taxed at ordinary income rates."

Third, commissions and expenses.  "ETNs are generally cheaper than mutual funds, but you'll have to pay a commission.  Your broker may tell you that you can buy an ETN on its initial offering with no commission, but that's not entirely true:  The commission is part of the initial offering price."

Waggoner concludes that, "Generally speaking, the more complex the deal, the more you should avoid it."  That's good advice.

Source: USA Today