ETFs' Newest Rival

Low costs and wide trading flexibility have made exchange-traded funds a hit on Wall Street. As asset inflows rise, dozens of new funds crowd into the market. Given these investments' popularity, it's no surprise that new, improved versions are now emerging. Investors, say hello to exchange-traded notes.                              

ETF version 2.0
Created by British financial-services giant Barclays (NYSE: BCS  ) , ETNs resemble ETFs -- with a few notable differences. With ETFs, investors actually buy into a portfolio of securities based on an index. But ETNs are debt securities, or notes, issued by Barclays Bank, which promises to pay investors the return of a specified index, minus an annual management fee.

While ETF holders face at least a minimal risk that their investment won't accurately track their fund's benchmark, ETNs shift that burden to Barclays. ETN investors are essentially banking on Barclays' creditworthiness, since the risk remains that the bank may not be solvent when they wish to sell their ETNs. I wouldn't lose too much sleep over that possibility, but stranger things have happened. Remember Barings Bank?

Beyond the added element of credit risk, ETNs may be more tax-efficient than ETFs. ETFs recognize capital gains and losses on an ongoing basis, as the underlying futures contracts in the fund roll over. ETNs don't make periodic income distributions, which means that investors don't pay taxes until they sell the ETN. Note that this tax advantage remains hypothetical, since the IRS hasn't definitively ruled on ETNs.

Limited availability
Right now, Barclays offers seven different iPath exchange-traded notes. Three track popular commodity indices: the GSCI Total Return ETN (NYSE: GSP  ) , the Dow Jones-AIG Commodity ETN (NYSE: DJP  ) , and the GSCI Crude Oil ETN (NYSE: OIL  ) . Another tracks the MSCI India Index (NYSE: INP  ) , while three new currency ETNs provide exposure to the euro (NYSE: ERO  ) , British pound (NYSE: GBB  ) , and Japanese yen (NYSE: JYN  ) . While their current offerings are limited, ETNs have plenty of room for future proliferation, likely in alternative areas such as timber or real estate.

Most investors probably don't need to worry about getting involved with ETNs right now. Few diversified investors need any specific exposure to commodities, India, or the yen. Stick to mutual funds or ETFs with broader mandates, and you'll have a much greater chance of keeping your investment portfolio on track.

But what if you are one of those rare (or stubborn) investors who insists on foreign currency exposure, either as a hedge or for speculation? Are ETNs or ETFs the better choice? That depends on two factors: what type of risk you're most concerned with, and how you want to manage your tax bill.

If you're concerned about tracking error, and you need the exact return of your target currency index, an ETN might be for you. But if credit worries you, ETFs may be more your style, since your payoff doesn't depend on a financial institution's solvency.

Likewise, if you'd rather defer your capital gains and income until the day you sell your investment, ETNs are ideal. But if you prefer ongoing income distributions, despite the tax bill, ETFs may suit you better.

It remains to be seen whether ETNs can truly challenge ETFs' dominance. ETNs have their advantages, but like any new investment product, their long-term viability isn't certain. If you choose an ETN, remember to look before you leap.

More exchange-traded Foolishness:

Shannon Zimmerman's Motley Fool Champion Funds newsletter can help you find the best mutual funds and ETFs on the market. Try it free for 30 days.

Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool has a disclosure policy.

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