The ETN Universe Is Shrinking

NEW YORK (TheStreet) -- When exchange-traded notes first appeared on the market in 2006, investors rushed to invest in what was heralded as the next generation of exchange traded products. Three years later, the ETN universe is contracting. Are ETNs a portfolio risk, or simply underutilized and misunderstood?

According to data from the National Stock Exchange, the total number of listed ETNs decreased from 90 in October 2008 to 84 in October 2009. As of Oct. 31, there was $699 billion invested in ETFs compared to only $7.6 billion in ETNs.

Like ETFs, ETNs trade throughout the trading day and track an underlying index. The most critical difference between ETFs and ETNs are the index components. While ETFs track baskets of stocks, bonds or derivatives, ETNs track "unsubordinated debt notes." The "N" in ETN is what sets these products apart.

Commodity ETNs offer certain advantages over commodities ETFs. ETNs are designed to have no "tracking error" between the product and its underlying index. While buyers of futures-based commodity products like United States Natural Gas(UNG) or United States Oil(USO) have to deal with futures market forces like contango and backwardation, owners of the iPath Dow Jones-AIG Commodity ETN(DJP) will get the return of the index, minus management fees.

A second reason to pick commodity ETNs over commodity ETFs is the tax treatment. Investors who hold a commodity ETN for more than one year will only pay a 15% capital gains tax when they sell the product. Futures-based commodity ETFs like PowerShares DB Commodity(DBC) are taxed like futures, and gains are marked-to-market each year. This 23% vs. 15% tax difference helped to herd commodity investors toward the ETN industry.