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Exchange-Traded Notes Can Be Better Than ETFs

They have less tracking error and are more tax-efficient.

Move over, exchange-traded funds.

ETFs, which are portfolios of securities, have taken the investment world by storm in recent years. Investors like the fact that they always know they're holding and can trade them throughout the day -- two big advantages over mutual funds. Last month, the number of ETFs available in the U.S. reached 570, nearly 60% more than at the end of last year.

But there's a new kind of investment product that has less tracking error than an ETF and is more tax-efficient.

Like ETFs, exchange-traded notes track a benchmark index and trade on an exchange. But that's where the similarities end. ETNs don't hold stocks, bonds or even futures contracts; they are senior, unsecured debt.

That means investors might not get paid if issuer goes belly up, althougth the two investment banks that offer ETNs to date -- Barclays Bank, a unit of

Barclays PLC

(BCS) - Get Report

, and

Bear Stearns


-- are generally considered good credit risks.

This debt isn't a bond, however. When you purchase a bond you expect to get your principal back -- unless the issuer defaults. But if the index the ETN tracks declines in value, so does your investment.

On the plus side, ETNs avoid two potential pitfalls of ETFs. Investors don't have to worry that an ETN's returns will move out of line with its benchmark index. Tracking error can be a problem for some ETFs, particularly if they can't hold all of the securities in their benchmark because there are too many or the constituents are too illiquid. In these cases, the sponsors may use futures, swaps or other instruments to approximate an index's return, sometime unsuccessfully.

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) - Get Report

, the

S&P GSCI Total Return Index

(GSP) - Get Report

and the

S&P GSCI Crude Oil Total Return Index

(OIL) - Get Report

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-- and the

MSCI India Index


, 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


, the

GBP/USD Exchange Rate


and the

JPY/USD Exchange Rate


-- and the

CBOE S&P 500 Buywrite Index


, which tracks a covered-call strategy indexed to the

S&P 500


The currency ETNs have an expense ratio of 0.40%, the same as the Rydex family of currency ETFs; the expense ratio on the covered call ETN is 0.75%.

Bear Stearns' first ETN, the

BearLinx Alerian MLP Select Index


, tracks energy-related Master Limited Partnerships. It was launched in July. Unlike the iPath products, it does make a income distribution on which investors must pay annual taxes

Although investors can also invest in currencies and commodities through a number of mutual funds and ETFs, these products don't have the same tax advantages as the iPath ETNs. For example, currency ETFs hold interest-bearing instruments in the specific currency are taxed as ordinary income, although not until the securities are sold.