JULY 9, 2007
The Magic of ETNs
ETNs (Exchange Traded NOTES) are the newest wrinkle from Barclays, one the largest sponsors of ETFs (Exchange Traded FUNDS). According to Barclays these iPath ETNs were invented to allow investors to access difficult asset classes.
Akin to ETFs, ETNs trade on an exchange and investors rely on market makers for liquidity. Also like ETFs, those market makers rely on a redemption process for their liquidity at Net Asset Value (N.A.V.). But the similarities stop there, ETNs are not a mutual fund like an ETF, investors do not own a proportionate “slice” of a portfolio. Instead ETNs are “senior, unsubordinated, unsecured debt securities” issued by Barclays Bank PLC. Unlike an ETF there is a credit risk to the sponsor.
ETNs are not notes at all but instead are forward contracts. Prepaid forward contracts guaranteed by Barclays to payoff at maturity the value of a notional amount invested in an index or strategy index. Unlike a traditional note, there is no principal guarantee and there are no periodic interest coupons paid. Unlike an ETF there are no distributions over the life of the contract .The value goes up or down with the designated index, there is no tracking error only a “management” fee.
The magic is that ETNs offer tax deferral and possible long term capital gains. We are advised that ETNs are taxed like a derivative security that realizes profits only upon sale. It is believed that if ETNs are held for more than 12 months any profit or loss should be taxed at long term capital gains rates. Although some reports have thrown doubt on this issue our advisers are unanimous in this view. Indeed, the iPath website observes that ”Barclays identified other issuers(not including Barclays) representing approximately 200 offerings for an aggregate amount of approximately $4.6 billion of securities…In each of these filings, the issuer or issuer’s counsel have generally provided tax disclosure or opinions similar to the tax opinion provided for iPath ETNs.” (These other issues were not listed to be traded on an exchange.)
The first ETNs were tied to a commodity index. There are both commodity ETFs and ETNs. They both have a 75 basis point (bp) fee. The ETF is a commodity pool owning futures and interest bearing collateral. Its profits are taxed and distributed as realized. In contrast, the ETN makes no distributions during its life. There is no tax due until the ETN is sold.
Asset classes and different payoff patterns are being added to the ETN stable all the time.
The latest ETN is tied to the BXM Covered Call index and can be best juxtaposed to a closed end fund dedicated to the same strategy, the S&P 500 Covered Call Fund (BEP).
The Covered Call ETN (BWV due in 2027) has a 75 bp fee and no tracking error.
BEP has a 90 bp management fee and other expenses that cause and all-in fee of slightly over 1%. BEP follows the BXM index religiously, buying the S&P Index and selling one month calls paying commissions and bid/ask spreads. These costs must cause a drag on performance.
BEP’s profits from index options are taxed 60% long term and 40% short term due to IRC Section 1256 (but they are also marked to market at the end of each year). Dividends have been taxed at 35%, not 15%, because the calls sold are not “qualified covered calls”. Ironically (we believe) BEP could have “qualified covered calls” by deviating from the BXM index slightly by selling 31 day (not 30) calls. In 2006, 72.5 % of BEP’s distribution was taxed at the highest rate, 17.5% as long term gain and.9.5% as a return of capital. Additionally, BEP is a closed end fund trading at a 15% premium to its Net Asset Value, if the fund does terminate on 3/31/10 as planned, that 15% premium will be lost over the next few years.
In contrast the BXM ETN has a lower fee, no distributions, is structured to have no “major” deviations from NAV and no should create no taxable income until sold.
Clearly the iPath ETNs are a product to be aware of and with these characteristics, they are sure to soon be imitated.
NOTE: AFTER THIS ARTICLE RAN IN INVESTMENT NEWS MUCH HAS HAPPENED IN WASHINGTON ABOUT ETNs. CURRENCY ETNs HAVE BEEN RULED TO BE DEBT AND PROSPECTIVE LEGISLATION HAS BEEN INTRODUCED TO LIMIT THE DESCRIBED BENEFITS OF ETNs. THE TREASURY DEPARTMENT HAS ALSO ASKED FOR COMMENTS ON WHY/HOW TO CHANGE THE TAXATION OF ETNs.