Exchange-Traded Notes Can Be Better Than ETFs

This difference can be significant. According to Morgan Stanley, the average tracking error of U.S. ETFs rose to 0.29% last year from 0.18% in 2005.

With an ETN, the only tracking error is the difference between the return of the benchmark and the management fee.

In addition, Barclays' iPath ETNs are also more tax-efficient than ETFs. Since they don't hold securities, investors don't have to worry about paying taxes on dividends or interest income. The iPaths themselves don't pay out interest, although there's some uncertainty about the tax status of their annual returns. For now, however, investors don't incur taxes until they sell them, potentially generating a capital gain.

"They work tax magic," says Robert Gordon, the chief executive of 21st Securities, a New York financial services firm. "You don't pay taxes during the life of owning them and if you get out after a year and day, these are long-term capital gains."

Barclays was the first to market with ETNs. Most track assets that are difficult for individual investors to trade. Last year it launched three commodity ETNs -- the Dow Jones AIG-Commodity Index Total Return (DJP), the S&P GSCI Total Return Index(GSP) and the S&P GSCI Crude Oil Total Return Index (OIL) -- and the MSCI India Index (INP), the only exchange-traded product that focuses solely on the Indian stock market.

The commodity ETNs all charge 0.75%, and the Indian ETN charges 0.89%. Already ETNs are capturing the interest of sophisticated investors.

This year Barclays rolled out three ETNs that track exchange rates -- the EUR/USD Exchange Rate ETN(ERO), the GBP/USD Exchange Rate (GBB) and the JPY/USD Exchange Rate(JYN) -- and the CBOE S&P 500 Buywrite Index (BWV), which tracks a covered-call strategy indexed to the S&P 500.