Exchange-traded structured notes: The gloves come off

A STORM IS gathering in the US financial markets, and it could have serious implications for banks hoping to profit from the rapid uptake of structured note investments by American investors. The Investment Company Institute (ICI), a Washington-based trade association representing the massive US mutual fund industry, has launched an intensive lobbying campaign to convince Congress to change the tax treatment of exchange-traded notes (ETNs). In November, it wrote to the Committee on Ways and Means – the House of Representatives body that handles tax legislation – asking it to "eliminate the unwarranted and unintended tax advantages" that retail ETNs – taxed as prepaid forward contracts – appear to have over mutual funds.

"Quick action is needed," urges ICI. "Unless the tax treatment of retail ETNs is corrected, mutual funds stand to become substantially less attractive to investors solely for tax reasons."

ETNs have a tax advantage over mutual funds in two respects. Investors in a mutual fund own the underlying securities and as such receive dividend income annually, which is taxed. Also, when a fund changes the composition of its holdings, such as when an exchange-traded fund (ETF) alters its underlying portfolio to track a change in the index it is following, the fund holder has to pay capital gains tax on the stock sold. An ETN, however, is structured as a pre-paid forward – a forward contract with payment made at the inception of the contract – so there is no interest or dividend payment. Instead, the realization of any gain or loss is based on when the investor buys and sells the investment. Investors who hold an ETN for more than a year therefore benefit from long-term capital gains treatment, which is charged at a lower rate than for short-term investments. Fund holders cannot benefit from long-term capital gains treatment because, for regulatory reasons, index mutual funds and ETFs have to distribute any gains to fund holders on a regular basis.

ICI wants to see ETNs and mutual funds treated as equivalent for tax purposes. Naturally, the possibility that a critical advantage that structured notes possess could disappear is not going down well on Wall Street, which sees ICI’s attempt to change the status quo as a desperate anti-competitive action on behalf of an industry now past its zenith. "The exchange-traded note market is poised for enormous growth, and I think it poses a threat to the mutual fund industry that they’re hoping to try to legislate away," says a New York-based structured products player. "For the first time they fear that the power of investment banking firms, and structured products in particular, will completely tip the balance in the way US investors invest. The mutual fund industry is quaking in its boots."

Anna Pinedo, a derivatives lawyer with law firm Morrison & Foerster in New York, adds: "ETNs are taking some of the business away from ETFs, and that is obviously a scary thing to the mutual fund industry, because they’re facing competition that they didn’t anticipate."

Fighting the structured note issuer’s corner is trade body the Securities Industry and Financial Markets Association (Sifma). Just a few days after the House committee received ICI’s letter, Sifma wrote a response in defence of ETNs. It argues that the change being sought would require holders of ETNs to pay tax on income they do not receive and might never receive (see box). "Taxing phantom income that is not actually received is an ill-advised policy that Congress should not pursue," says Sifma. "Investors should be taxed on income when it is received, as under current law." Sifma believes ETNs do not directly compete with mutual funds, and that they pose different types of risks and provide different exposure to that investors typically get with funds.

"We created something that is liquid, very simple and very transparent" Philippe El Asmar, Barclays Capital

The market in its present form got off the ground in June 2006, when Barclays Capital launched its iPath series of products, which are listed on the New York Stock Exchange and the American Stock Exchange. "We created something that is liquid, very simple and very transparent. The investors buying our products know what they are getting, a one-to-one exposure to a region, an asset class or a market," says Philippe El Asmar, head of investor solutions, America, at Barclays Capital

There are 25 ETNs on the market, 16 of which are issued by Barclays Capital. Eleven of these offer exposure to various commodity indices, three are linked to currency plays, one is linked to the MSCI India equity index, and one is linked to an S&P 500 covered call writing strategy. Barcap estimates that about $4 billion has been invested in iPath products since launch. The rapid uptake of the products has prompted a number of Barcap’s competitors to enter the market this year. Goldman Sachs, Bear Stearns and Deutsche Bank have all launched ETNs, and JPMorgan has plans to launch commodity-linked and other types of ETNs. Insiders say that every big investment bank operating in the US market that has not launched ETNs is likely to be drawing up plans to open for business soon.

In the third quarter, Deutsche Bank launched ETNs linked to the Morningstar Wide Moat Focus Total Return Index, which aims to track companies with continuing competitive advantages, and one linked to the Dow Jones High Yield Select 10 Total Return Index, better known as the "Dogs of the Dow" strategy, which invests in the 10 Dow Jones Industrial Average stocks with the highest dividend yield, holding them for a one-year period. "We are aggressively pursuing the ETN space. We are likely to offer five more deals before the end of the year," says Christopher Yeagley, managing director and head of global investment solutions for the Americas at Deutsche Bank in New York.