Saving & investing: The pros and cons of exchange-traded notes

As if the burgeoning world of exchange-traded funds weren't confusing enough, a new type of exchange-traded product has hit the market: exchange-traded notes, or ETNs.

ETNs and ETFs both function like low-cost index funds; the differences are under the hood. An ETF consists of a portfolio of securities (or sometimes a cache of gold or silver bullion), and owning a share gives you claim to a small portion of that portfolio.

With an ETN, however, there is no portfolio. You get what is, in essence, a bond issued by the ETN's creator, Barclays. The ETN promises to repay the amount of your investment plus (or minus) the return of the index that the ETN tracks, less a management fee.

Barclays, one of the world's biggest ETF managers, issued its first two commodity-focused ETNs, iPath S&P GSCI Total Return Index (symbol GSP) and iPath Dow Jones-AIG Commodity Index Total Return (DJP), in June 2006. Since then it has issued six other ETNs (with four more due this summer).

If all goes well, ETNs should act much like ETFs — or better, in some ways. For example, the trading price of ETF shares can sometimes stray from the value of the underlying portfolio. But with ETNs, that's not a problem because Barclays promises to pay exactly the index's return minus fees, which range from 0.4 percent yearly for currency ETNs to 0.89 percent for a fund that tracks Indian stocks.

As for taxes, ETNs don't pay cash distributions — the value of dividends, interest and investment gains is lumped into the funds' total return. So you won't face any taxes until you sell your shares. And even then, any gains on shares held more than a year should be taxed at 15 percent, according to a legal opinion Barclays obtained. In contrast, 40 percent of gains from ETFs that hold commodities futures and 100 percent of gains from currency ETFs are taxed at higher, ordinary income-tax rates.

What's the downside? The Internal Revenue Service has not weighed in on the proposed tax treatment, so some uncertainty remains. In addition, ETN investors could suffer if Barclays' ability to repay the bonds ever came into question. That's unlikely — Barclays is one of the world's biggest financial institutions — but you can't dismiss the prospect entirely.

Most of the indexes tracked by ETNs are also tracked by ETFs. If you are investing in a tax-deferred account, stick with ETFs for now. ETNs could well be the better option if you invest in taxable accounts, but you probably should give them more time to prove themselves before you jump in.