ETNs are enjoying steady growth

As more companies begin to offer exchange traded notes, it's beginning to look like the small but growing ETN universe could one day be a competitor to mutual funds and exchange traded funds. "ETNs are definitely a threat," said Jeff Ptak, director of exchange traded securities analysis at Morningstar Inc. of Chicago. That's a problem for traditional asset managers because unless they partner with an investment bank, they may not be able to offer ETNs, which are actually debt instruments linked to an index. Consequently, it's easier for an investment bank to bring an ETN to market than it is for a traditional asset manager. A look at some of the companies offering ETNs illustrates the point. UBS Investment Bank of New York, a unit of Zurich, Switzerland-based UBS AG, launched eight ETNs earlier this month. The UBS E-TRACS ETNs are the first of many the company hopes to launch before the end of the year, said Kurt Nelson, a managing director and head of ETNs at UBS.

GROWING RANKS

Last month, Morgan Stanley of New York listed its first ETNs, the Market Vectors-Chinese Renminbi/ USD ETN and the Market Vectors-Renminbi/USD ETN. Lehman Brothers Holdings Inc. of New York stirred things up in February when it launched Opta, an ETN platform, and three Opta exchange traded notes. The launch of Lehman's ETN platform followed the launch of the Elements ETN platform last August. Elements ETNs, of which there are nine, were brought to the market by a partnership that includes index providers, investment-grade issuers, distributors and securities exchanges. Issuers include Deutsche Bank AG of Frankfurt and Swedish Export Credit Corp. of Stockholm. Distributors include Merrill Lynch & Co. Inc. of New York and Nuveen Investments LLC of Chicago. The first ETNs were launched by Barclays Bank PLC of London in 2006. Barclays has been able to amass more than $5 billion in 16 iPath ETNs distributed by Barclays Global Investors of San Francisco. Investors should expect even more providers to jump into the ETN market, Mr. Nelson said. "We think that ETNs are here to stay," he said. ETNs are able to provide investors access to markets that are difficult to reach using ETFs and mutual funds, Mr. Ptak said. For example, the UBS E-TRACS CMCI Food Total Return ETN is pegged to the first commodity index to provide direct exposure to food, Mr. Nelson said. At a time when food prices are rising, it's a potentially attractive investment, he said. That may be true, but ETNs have issues that can pose problems for investors.

PROBLEMS

The biggest is that as debt they are backed by the issuer of the ETN, Mr. Ptak said. That can be a problem if the issuer runs into trouble, he said. The recent collapse of The Bear Stearns Cos. Inc. of New York illustrates the point, Mr. Ptak said. Had JPMorgan Chase & Co. of New York not made a bid to acquire Bear, investors in the BearLinx Alerian MLP Select Index ETN, launched in July, might not be very happy. But JPMorgan did step in, and the ETN, which has more than $100 million in assets, is doing OK, Mr. Ptak said. Barring any future blow-ups, new ETNs will continue to come to market, he predicted. In a move some industry ob-servers said they believe is an attempt to blunt such growth, the Investment Company Institute, the Washington-based mutual fund trade organization, has lobbied to torpedo the tax advantages that ETNs enjoy over ETFs and mutual funds. The ICI, for its part, has maintained that it is interested only in leveling the playing field between ETNs, ETFs and mutual funds. ETNs are treated as prepaid forward contracts for federal income tax purposes, meaning that an investor does not realize any income or recognize any gain until the ETN is sold. Even if ETNs lose the tax advantage they have over mutual funds and ETFs, that may not be enough to stop them from spreading. They cost very little to launch, said Geoff Bobroff, a mutual fund consultant in East Greenwich, R.I. ETNs are so inexpensive to produce that he said he's "surprised" more investment banks haven't already jumped into the market. E-mail David Hoffman at dhoffman@investmentnews.com.