Exchange-traded structured notes: The gloves come off

Clash of the trade groups – ICI’s positions versus Sifma

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.

Similar to the European certificates market, US ETNs are debt securities that have to date been structured as simple, linear "delta one" products linked to the performance of an index. They structurally differ from ETFs in that ETFs hold a basket of securities and a share in the fund constitutes a portion of those assets. An ETN, on the other hand, is not backed by a specific pool of assets. Instead, it is simply an agreement between the issuer and the buyer to give the buyer the returns of an index or benchmark. 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.

Booming market

Investment banks see structured notes, both through on-exchange and over-the-counter sales, as a key growth area for their US businesses. However, whether the product could threaten the massive mutual fund industry is another matter. Estimates of assets under management in US mutual funds are in the $10 trillion range, according to ICI, compared with a little over $4 billion in ETNs. The over-the-counter market is much bigger, but structured notes still form a tiny part of US investment markets overall, although they constitute the fastest-growing investment class, according to the Structured Products Association (SPA), a New York-based trade body, which believes the current growth in structured products is akin to where the ETF market was four or five years ago.

"The structured products business here in the US is growing by leaps and bounds," says Michael Camacho, head of structured investments for the Americas at JPMorgan in New York.

In 2006, US investors bought $64.3 billion-worth of structured products, up 32% on the previous year’s $48.7 billion. In the first quarter of 2007 there were 1,179 new structured products (mainly over-the-counter notes) issued by nearly two dozen providers, representing nearly half the 3,300 structured products issued in all of 2006, according to structuredretailproducts.com, a data website. The SPA estimates that when the figures come in early the new year, 2007 will prove to be the US structured products industry’s first $100 billion year. Perennial problem

But continued rapid growth for structured products is not an absolute given in the US. The sub-prime crisis and the credibility hit that structured investments took on the back of it earlier this year, for example, could indirectly cast a negative tinge on the structured notes market, although Keith Styrcula, the SPA’s chairman, insists that sales remained relatively robust throughout the third quarter. "Anecdotally, from speaking to heads of desks, structured products issuers have been extremely busy over the last few months and are reporting record revenues," he says.

A perennial problem for structured note issuers is how to effectively market their products to show that they offer a very different proposition to structured credit and other types of asset-backed securities. Structured notes can be defined as derivatives-based investments where the derivative is used to replicate, synthetically, exposure to a particular market or index return. Confusion can start to kick in because lots of people relate structured products to complex forms of structured credit, such as synthetic collateralized debt obligations (CDOs). "Structured finance is different from structured products, but they both come under the umbrella of structured investments," says Styrcula.

In part, the confusion was created by the credit rating agencies when Moody’s and Standard & Poor’s opted to call their CDO rating groups structured products groups, he adds. This error, as Styrcula sees it, has been compounded by much of the financial media, which over the past year has started to generically refer to CDOs and other structured finance vehicles as structured products. Although the volume figures do not show it, some US investors will undoubtedly have been put off investing in derivatives-based products because of the negative connotations associated with the structured products tag.

Dealers in the US have had to work hard to convince investors, particularly retail investors, of the merits of derivatives-based investments. Culturally, US investors are more willing to accept equity-market levels of risk in comparison to their European counterparts, which means they have traditionally not been as interested in managing their downside risk. "Structured products in Europe and mutual funds in the US are mature industries with lots of growth and development acceptance by investors, while structured products in the US and mutual funds in Europe are still young, comparatively," says Deutsche Bank’s Yeagley. Also, there is a tax disadvantage on taxable accounts for principal-protected products in the US, which means the most popular structures tend to either only offer partial downside protection, or no downside protection and a leveraged upside.

It is for these reasons that the US structured products market is said to lag behind Europe in terms of volumes and product development, at least on the retail side. The genesis of today’s global structured note market lies in Europe, and in particular with equity derivatives desks at major European dealers, which led the way in mass marketing equity-linked, principal-protected notes as a way to convince risk-averse European retail investors to take exposure to equities. It is no surprise then that some of the biggest structured note players in the US are European. Lacking a well-known US brand name, banks such as Barclays Capital have had to fight to establish a presence, and it is a presence that still looks precarious in relation to the much bigger mutual fund industry.

Europe vs US

Indeed, some people view the argument over taxes as a struggle between a predominantly European-dominated structured products industry and a US-dominated mutual fund industry. "Most of the investment company complexes are domestic US companies, like Vanguard and Fidelity, but a lot of the entities that have been selling ETNs in the US are foreign banks," says Morrison & Foerster’s Pinedo. The fear of dealers is that the Committee on Ways and Means could opt to protect the largely US mutual fund industry against foreign competition.

So what are the chances that legislators will fall in with the mutual fund industry’s wishes? Pinedo thinks Congress will definitely take ICI seriously. "They have the pressure of having to raise additional tax revenue and this could be an easy way to do it. Also, ICI is a very large trade body; they are very well connected here in the US and are very effective at lobbying," she says. One issue not yet addressed is the possible wider repercussions beyond the listed market that any change in the tax law would introduce. As one New York dealer notes: "While Congress has been asked to look at ETNs specifically, what happens if you are doing delta one certificates that are not exchange traded? Any ruling would have ramifications across the structured products industry." So any ruling might affect not just the $4 billion exchange-traded market but also the potentially $100 billion, and rapidly growing, broader structured note market.

With every big dealing house investing heavily to launch ETN businesses, or expanding the ETN businesses they already have, removing the tax advantage notes enjoy could have a seriously detrimental effect on the one part of the structured products market that guarantees transparency, liquidity and accessibility. That would be a big blow to Wall Street, and dealers would say it would be a big blow to investors. No date has been set for when the Committee on Ways and Means will make a final ruling on the taxation of ETNs. Until it does, structured product issuers will be biting their nails in anticipation.