The overall concept behind exchange traded notes (ETNs) isn’t exactly new, although the form they take today is.

An ETN is a debt instrument the issuer promises to pay a specified return, based on the market index’s performance, and they trade throughout the day like a stock. So far this year, 63 ETNs have launched. Morningstar tracks 89, with $7.3 billion in assets. They’re still small in number compared with ETFs: there are 732 in existence, with $586 billion management.

Issuers so far have typically been large financial service firms, such as investment or commercial banks.

Shefali Anand for The Wall Street Journal says that ETNs track commodities, currencies and the stock markets of single countries. ETNs have been around since the 1990s as “structured notes” made available for wealthy clients and institutional investors.

In 2006, BGI issued a structured note that was traded on a stock exchange in small units, creating the very first ETNs:

• iPath Dow Jones AIG Commodity Index Total Return Index (DJP), up 7.1% year-to-date
• iPath GSCI Total Return Index ETN (GSP), up 20.1% year-to-date

Today, ETNs have become popular investment tools for financial advisors who are trying to pinpoint a certain asset class. Most of the ETNs are special and the exposure could not be set up the same in an exchange traded fund (ETF). If you are an individual investor, it is wise to do your research before jumping in. You want to understand their key differences from ETFs.

An ETN is not backed by assets. It is unsecured debt by the issuing form and there is credit risk. If an ETN liquidates, there would only be money to give back to investors if there was money left over after the secured creditors were paid.

ETNs are treated as prepaid contracts for tax returns. Capital gains or losses must be reported and upon sale or redemption or maturity. Single-currency ETNs have been determined as taxable as ordinary income. Many of the issues surrounding tax treatments of ETNs from iPath are under scrutiny of the U.S. Treasury and IRS, so treatments may fluctuate.

Tags: Commodity ETFs, Currency ETFs, DJP, ETNs, GSP