Weak-Dollar Play: New 'ETN' Could Shine

It promises higher returns, lower taxes than ETF rivals.
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Barclays has come up with a new way to profit from a weak dollar that promises higher returns and lower taxes than conventional exchange-traded funds, but there are also some significant risks to consider.

Last week, the U.K. bank rolled out three exchange-traded notes -- a kind of senior, unsecured debt -- linked to the performance of the euro, British pound and Japanese yen relative to the U.S. dollar.

The

iPath EUR/USD Exchange Rate ETN

(ERO)

,

iPath GBP/USD Exchange Rate ETN

(GBB)

and the

iPath JPY/USD Exchange Rate ETN

(JYN)

trade on the

NYSE

.

Currencies have been gaining respect as an asset class. They can be used for diversification, due to their low volatility and low correlation to other markets. U.S. investors can hold foreign money to protect their portfolios from a weakening dollar.

ETFs, which resemble index mutual funds but trade on an exchange like stocks, are a popular way to get involved in the market.

Rydex

has launched eight currency-based ETFs since December 2005, including the popular

CurrencyShares Euro Currency Trust

(FXE) - Get Report

, which in April reached $1 billion in assets.

Unlike CurrencyShares, which hold hard currencies, the new Barclays iPath products are notes from the bank promising to pay you a return based on movements in the exchange rate between the two currencies. If you take a long position in the GBP/USD Exchange Rate ETN and the value of the pound goes up versus the dollar, you make money. You can short the ETN if you expect the dollar to get stronger instead. The funds based on the euro and the yen work the same way.

ETNs aren't for investors seeking regular income. They don't pay dividends like Rydex's currency-based ETFs. However, there are some other advantages.

Because you are not receiving monthly payouts, you won't have to pay taxes on your ETNs until they mature or you sell your shares.

Even then, it is possible you will be taxed at a lower rate. Outside advisors have told Barclay it is possible ETNs could be treated as prepaid contracts, meaning they would be subject to long-term capital gains tax, with rates that only go up to 15%.

Rydex says gains from their currency-backed ETFs are subject to regular income tax rates of up to 35%.

The tax savings could be significant, but it's not a sure thing. The IRS hasn't made an official ruling yet on how to handle gains from ETNs. "Each investor should evaluate the tax treatment of any investment product with their own tax advisor," says Philippe El-Asmar, head of Barclays' investor solutions teams for the Americas.

Investors also need to understand they won't own an asset; they will own Barclays' debt. It may seem unlikely, but if this large banking firm was to default, you could lose your money.

One trait ETFs and ETNs share is low fees. Both the iPath ETNs and Rydex's currency ETFs charge just 0.4% in annual expenses.

While their risk profile and distribution model may not be for everyone, exchange-traded notes represent an intriguing option for some investors. Over the past year, Barclays has launched seven ETNs, including ones with exposure to commodities and emerging markets. They have attracted more than $2 billion in assets.

El-Asmar says Barclays has more ETNs on the way. "This is a new but growing investment class," he says.

To see Gregg Greenberg's TheStreet.com TV interview with Philippe El-Asmar , click here.