Thanks for providing some clarity on these new issues, Matt. Did you or Jim happen to see David Merkel's piece today taking a shot at our latest blogs on ETNs?

He starts out by reminding everyone he's written about ETNs before (at Jim Cramer's RealMoney hangout, no less ... boo-ya!). Then, he takes a jab directly at us: "Now, today, I find it funny to see other retail investment commentators catching up with the credit risk angle of ETNs."

Note: Part of this sentence is linked; clicking on it leads to Jim's latest blog on ETNs ...

Even though it was far before my time here, even I realize that these issues were hotly reviewed and discussed from the first day ETNs came on to the scene at IndexUniverse. That was in June 2006 when Barclays registered with the SEC to issue its first iPaths. (I know this because I was covering ETFs exclusively for another publication at the time and considered it my business to keep up with these sorts of developments.)

Not counting all of the other IU blogs between Matt and Jim, as well as the articles that've appeared in its sister publications, the Journal of Indexes and ETFR (Exchange-Traded Funds Report), I'd say Mr. Merkel's a little off base in referring to this latest blogging thread as "catching up."

I'd also like to remind anyone keeping score that these blogs were started by me ... and as anyone who has been reading can attest, my knowledge and understanding of everything exchange-traded falls far below that of my colleagues here at IU.

I blogged ‘cause it seemed like a pressing and very relevant issue to many ... I thought our esteemed staff's expertise could help shed some more light on these issues ... I didn't mean to suggest they hadn't been addressed before. That's a generalization I'd expect to be made about a mass-circulation-minded publication.

To make a long blog short, David Merkel's a great analyst. If you've never read his stuff, it's worth a gander. But I found this one lacking, not only for its off-the-mark poke at us but also how he suggested that his experience in pension funds, variable annuities and equity indexed annuities (among other things) gave him an edge.

Nothin' wrong with that experience (cough, cough) ... but here's what gets me: He uses that background to try to explain why he was so far out in front of everyone else on ETNs (he gets it more than most?) ... and then compares ETNs to zero-coupon bonds.

Such a tie-in makes a lot of sense. It made so much sense that I tried to write a similar analogy at another publication in 2006 as well. It didn't fly with my editors, who told me they understood institutional markets extremely well ... they said it wasn't a fair comparison. I was advised never to compare notes to bonds except in the broadest of senses. Needless to say, they scuttled the copy and it never saw the light of day ...

But Merkel does propose an interesting way to get around the risks ETNs pose to investors. Far be it for me to say this sounds rather convoluted, but be your own judge: "Now, what if the sponsors packaged the ETN with a default swap (written by third parties) to protect the investors if the company failed? At that level, the ETN provider should buy Treasuries or Agencies, and layer on the futures or options as the case may be, creating an ETF, because all of the advantage from doing the ETN goes away."

Murray, you seem to be relaying worries about the motives of the product issuers. Here's the dirty little secret: All product issuers (with the exception of Vanguard) want your money. They want as much of it as they can get.

Do I wish ETNs were cheaper? Yes.

Do I wish banks would lower fees? Yes.

Do I think banks are launching ETNs because the process is cheaper, faster and more efficient than the process of launching ETFs? Yes.

Does that make them "good" or "bad" products? I don't think so.

What matters is how they perform for investors, and to that end, Jim has it right: The big issue is credit risk vs. tracking error (although please read my explanation of ETN tracking performance below, because Jim's got it wrong.).

How Real Is The Credit Risk?

I go back and forth on how important the credit risk is. The risk is tiny. But it's real.

I think anyone who held the BearLinx ETN through the Bear Stearns implosion was either nuts or ignorant. There was significant risk of Bear Stearns going bankrupt. You had zero upside and 100% downside for holding that note.

Then again, it all turned out OK. It usually does. Heck, even Barings Bank made good on its credit promises in the end. You'd need an unprecedented bank failure to lose out on one of these things. But crazy things do happen.

A Point Of Clarity On Tracking Error

I want to clear up one thing Jim said that is factually inaccurate. Jim listed "perfect tracking" as the No. 1 benefit of ETNs.

Not true.

ETNs don't guarantee zero tracking error. ETNs guarantee that institutional investors can redeem them at full value on a daily or weekly basis. They will never trade below the value of their index over the long term.

But there's no guarantee they won't trade above their net asset value, and that is an important distinction.

The iPath MSCI India ETN traded at a huge premium to net asset value for many months last year, after the Indian government clamped down on foreign investment. Investors who bought the note when it was trading at a premium have significantly underperformed the index over the past six months as that premium has disappeared.

This is not a technical point. ETNs are focused on illiquid markets. The lesson of the India ETN is that when markets get really illiquid, funny things can happen.

Always check to see if an ETN is trading at a premium to NAV before buying.

Perhaps I wasn't clear enough in my "rant" ... these are issues that people in the industry are talking about, and I'm listening. That's all ...

I'd like to reinforce the concept of journalism here. These blogs are difficult for those of us on the ground, so to speak, covering stories each and every day ... if I used this forum to voice my own opinions, nobody would sit for an interview unless they felt like I was on their side. And that would be a very tiny crowd indeed ...

I'm not taking sides here, Jim. All I'm trying to do is bring up issues that I hear about in the course of doing my due diligence as a reporter and editor. The executives I'm talking to about these issues, right or wrong, have a proven history of putting their customers first. When they speak, I tend to listen.

Given that rambling introduction, I've got to point out some holes I see in some of your responses.

First of all, does your "four-pudding" argument really represent the best interests of most index-minded, long-term investors? It places costs next-to-last in terms of priorities. I'd say a lot of people would put that first.

Along those lines, while ETNs are competitive with many similarly classified ETFs, can't they still be seen as a way to keep moving expense ratios higher, rather than in the opposite direction? I make this observation realizing that in a competitive marketplace, prices tend down rather than up. And while there's much debate about which way expense ratios are going for the industry as a whole, generally ETFs and ETNs are much less expensive than their actively managed mutual-fund counterparts.

The fact is, in every market, there are higher-priced products and lower-priced ones. I've just heard a lot of grousing that ETNs don't necessarily need to land in the higher-priced category all of the time ... the key question here is, why do expenses need to be so high on ETNs if banks and asset managers hold these notes themselves? Wouldn't this streamlining of the process indicate LOWER expense ratios in categories where they've got ETF competition?

Also, on the one hand, you're arguing that issuing notes reduces tracking error. On the other hand, you concede that there are transparency issues with ETNs. Doesn't this present a particularly thorny double standard for investors?

(Not to mention the fact that this line of reasoning seems to be suggesting ETFs have a real problem with tracking error ... not true. Some complexes and some types of asset classes tend to have more difficulty than others ... but to indicate that all ETFs have tracking error hiccups would seem like a gross overgeneralization, wouldn't it?)

Finally, it just seems like the three negatives you list to summarize the differences between ETFs and ETNs really DON'T equate to one major issue ... can you really reduce all of this debate into a single discussion centering on credit risk?

By the way, I've heard others try to associate notes used for years by institutions in addressing the ETN marketplace ... but that's not an apples-to-apples comparison. There are a lot of different types of notes out there and they tend to be even less transparent and more illiquid than anything we're dealing with open to retail investors ... so let's not go there!

I'm not sure what gets people so fired up about ETNs. I think it's mostly about market share. Let's look at them from the INVESTOR'S standpoint.

Murray - You focus (in a pretty decent blog post) on the marketing aspects, double counting by firms and the facts that ETFs can do anything ETNs can. As an investor, I really don't care about all of that. All I really care about is the pudding. And for me the pudding is 1) Does the vehicle deliver the asset class? 2) How is the tracking? 3) What are the expenses? 4) Are there any risks in the product structure?

That's really all I care about. And if the fund company wants to try to sell the product using dancing cats that are smoking cigarettes, I really could care less.

So first, let's take a clear-eyed look at the positives and negatives of ETNs.

Positives:

1. Perfect tracking
2. Institutional scale/state-of-the-art
3. Cleaner structure from an investor standpoint
4. Possible tax advantages
5. Access to investment areas that might otherwise be impossible to invest in (Murray is wrong that ETNs don't better open up less-liquid asset classes for tradable funds).

Negatives

1. Credit risk
2. Lack of transparency in what is going on with the underlying (notes)
3. Lack of direct ownership in underlying securities (if by that we mean what the notes are trying to track)

Really, those 3 negatives only come down to ONE thing: It is the ONLY thing really wrong with the note structure. That is the credit risk associated with the issuer of the notes that underlie the funds. Just one itsy bitsy teensy weensy issue. But it is a doozy.

In so many ways I love notes, and I'm fully aware that large institution have trusted in them and gotten tremendous scale and tracking benefits from them over the years. But the fact of the matter is that the structure leaves itself open to possible abuse, on the margins or wholesale. Because what's happening is that the fund is taking my money, a large institution is writing notes giving me a guarantee of a certain index's return, and then, well who knows what is going on after that with the note issuer? Think of it as sort of when you give your money to a bank that pays you interest rates, but then there is a wide array of things they can do to MAKE money off of YOUR money. Only this form comes without government insurance.

And there is little question that Murray's point about the appeal of the products to investment banks has to do with the fact that they can sort of double dip, getting paid an ER on the funds, and getting paid by the fund for writing the notes. So how do they do that (build in some extra cost) and still deliver perfect tracking? There's obviously a little extra risk built in there somewhere for someone. Generally, it will fall on the bank, until the bank falls. Do I think Barclays Capital has it covered? Well, yeah. But even with them, there IS a small risk. And more importantly, where do we draw the line on how secure the issuer of the notes has to be?

It's just a can of worms. And the bigger these things get on the retail level, the more the SEC is going to have to look into, and potentially regulate, how the notes themselves are covered. I would love to see this debate opened up, so let's see your comments...and I've got another roundtable for you Matt - an ETN vs. ETF debate with the most knowledgeable people on either side.

One thing is clear: ETNs are a VERY different creature form ETFs, not just a marketing gimmick. Accordingly, we need to do a better job covering (and differentiating) them on this site, in the wider financial media and in the industry.

Two sides are forming. Both seem entrenched and both are putting much of the blame on those of us in the media.

Whether such notoriety is really deserved, reporters are smack dab in the middle of this one.

At issue is whether exchange-traded notes, the latest marketing term created by the hyper-growth exchange-traded securities industry, are really much more than a bunch of hype. Does the world really need another form of exchange-traded funds?

Both ETFs and ETNs hold baskets of securities. The argument for ETNs is that they can go where most ETFs can't go - niche markets such as currencies and commodities. The idea is that by issuing notes replicating returns of an underlying index, shareholders can avoid pitfalls of actually buying portfolios of securities in often illiquid markets. Notes also can be used much more readily to purchase futures contracts and other more exotic financing vehicles to gain exposure to different asset classes.

But some in the industry are complaining that ETFs can do much the same. In fact, they are in many cases. Critics contend that ETNs are simply a new brand name that in essence repackages the flooding fields of ETFs. I've also heard arguments that since ETN providers hold their own notes in many of these newer products (Barclays, Deutsche Bank, etc.), the main innovation being brought to market is a way for big asset managers and banks to retain more assets directly. It can also help those issuing notes to eliminate more middlemen in transactions.

Another point of contention seems to be that a lot of those of us in the press like to emphasize that ETNs come with more risk since the notes are only as good as their underlying issuer. But what about risks associated with smaller ETFs with less than $200 million in assets and low trading volumes? Isn't that a bigger concern than a global bank going under?

Should risk attributes be a defining way to classify new exchange-traded financial products?

In some circles, journalists are being blamed for not being discerning enough. The criticism is that we're buying too readily these various new labels being thrown at investors.

Are investors (and reporters) being bamboozled by Wall Street's marketing prowess again?