The Next Generation Of Index Investing

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BERLIN – Exchange-traded notes are simple, transparent index trackers, and they give you access to hard-to-reach asset classes.

As a strategy, indexing makes sense for many investors. Rather than try to beat the market, they join it, choosing investments that track such benchmarks as the S&P 500 or the Russell 2000. Since the 1970s, however, when the first index mutual fund was created, there has been a quest to develop the right structure to execute the investment strategy. One innovation, the exchange-traded fund (ETF), lets investors trade a fund during market hours, just as they would a stock, as opposed to index mutual funds, which trade only at an end-of-day value. Now another contender — the exchange-traded note, or ETN — could prove better at indexing than its predecessors.

An ETN is a debt instrument, the performance of which is linked to an underlying market index. It is not a fund holding a portfolio of securities, as both ETFs and traditional index mutual funds are. Therefore, although ETNs can be bought and sold as if they were stocks, no stocks are actually purchased by the company issuing the ETNs. For this reason, they do not generate trading expenses that can erode returns; investors will not pay anything beyond the predetermined annual fees disclosed in offering documents, either at maturity or redemption (repurchase by the issuer).

When changes to an index force an index mutual fund or ETF to sell a security at a profit, a taxable capital gain may be produced. ETFs and index mutual funds also receive taxable income from stock dividends or bond interest payments, and at least once a year they must distribute these capital gains and income to shareholders. These distributions are taxed at the time of distribution. Unlike ETFs and index mutual funds, investors in ETNs will receive no distribution or interest on their investment, and they currently are taxed only at the time of sale, repurchase or maturity.

A benefit of ETNs is that they make it simple to invest in such hard-to-access asset classes as commodities..

In the short history of exchange-traded notes, it appears for now that the risks of this new investment do little to undercut its potential as an effective vehicle for tracking even remote investment markets.

(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)

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