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Goldman Launches Second of Planned ETNs: Can Nascent $4 Billion Category Take on $572B ETF Giant?

Goldman Sachs has debuted its second of several planned exchange-traded notes (ETN), the Claymore CEF Index-Linked GS Connect. The new ETN began trading on the NYSE Arca on Dec. 10.

Exchange-traded notes are senior, unsecured long-term notes issued by investment banks and have only been available since June 2006. An ETN is more tax efficient than an exchange-traded fund because it is not required to distribute dividends to investors every year (see MME 8/3/07, 10/22/07). It can also track indexes more closely and cost less because it owns a single note tracking the benchmark rather than individual stocks. However, according to one industry estimate, while ETFs had $572.12 billion at last count as of the end of November, these notes have already amassed $4 billion.

That hasn't escaped the notice of other Wall Street firms eyeing the launch of their own potential exchange-traded notes.

The Claymore CEF Index-Linked GS Connect ETN's underlying index was created on Dec. 5 and is comprised of a variety of closed-end funds from across different asset classes. At inception, the index was 30% weighted in fixed-income closed-end funds, nearly 28% in U.S. equity closed-end funds and almost 24% invested in closed-end funds that invest in international equities. Smaller amounts are invested in international fixed-income, global equities and U.S. government and agencies securities funds.

The index was created by Claymore Securities of Lisle, Ill., and includes closed-end funds that meet certain specific criteria for volume, minimum share price, operating history and market caps.

Enhanced Yield, Discount

"Goldman Sachs' new ETN composed of closed-end funds is an interesting concept," said Kevin Mahn, managing director of Hennion & Walsh, a broker/dealer in Parsippany, N.J. This past summer, Hennion & Walsh debuted a unit investment trust, the Hennion & Walsh SmartTrust Diversified Dividend Trust, that invests exclusively in 13 closed-end funds from across different third-party managers.

"Closed-end funds tend to offer enhanced yield opportunities, which can greatly assist portfolios whose primary objective is income. Further, the discount/premium trading nature of these products can create additional value with respect to the timing of the purchases within the portfolio," Mahn added.

GS Connect is the banner marketing name that Goldman Sachs' ETNs will carry. The very first Goldman Sachs ETN, the S&P GSCI Enhanced Commodity Total Return Strategy Index, debuted July 31 and tracks to a basket of commodities contracts across the energy, industrial metals, agricultural products and precious metals sectors.

Although Goldman Sachs developed the flagship ETN's index, the firm sold it to Standard & Poor's in February 2007. S&P also owns all rights to sub-indexes and certain intellectual property related to the commodity index.

This past November, Goldman Sachs executives announced that the firm was developing a series of GS Connect ETNs to follow the flagship one.

"Building on this momentum, we are developing a series of products that will provide access to difficult-to-reach markets and sectors, outperformance against traditional benchmark indices, and potentially algorithmic and cost-efficient alpha across asset classes," said Karen Fang, managing director, Goldman Sachs.

A company spokesman confirmed that other ETNs are on the way, but declined to provide further details.

Barclays Global, a unit of Barclays Bank, pioneered by launching the industry's first ETNs in June of 2006 under the iPath brand name. The firm now offers a total of 16 ETNs: 11 that track to commodity indexes, three currency ETNs, one emerging market (India) ETN and one strategy-specific ETN.

Several investment banks and securities firms followed suit. Merrill Lynch now distributes seven ETNs under the ELEMENTS brand name. UBS launched its own ETN earlier this year as well.

Taxing Times for ETNs

But ETNs have landed at the center of a quagmire. The Investment Company Institute has been petitioning for Congress to move swiftly in enacting legislation that would appropriately tax the earnings on ETNs.

In a Nov. 1 letter to Congressional leaders of the House of Representatives Committee on Ways and Means, ICI President Paul Schott Stevens asked Congress to remove the favorable tax treatment available to those ETNs that are taxed as prepaid forward contracts. "The legislation we seek would eliminate the unwarranted and unintended tax advantages that these retail ETNs appear to have over mutual funds," Stevens wrote.

Because they are newfangled investment products, ETNs do not neatly fit within existing tax laws. Without formal tax rules, ETN product providers, on the advice of legal counsel, had been assuming ETNs would be taxed a certain way. That tax treatment, the ICI charged, is giving ETNs an unfair advantage over mutual funds.

"Unless the tax treatment of retail ETNs is corrected, mutual funds stand to become substantially less attractive to investors solely for tax reasons," Stevens added.

The Internal Revenue Service dealt a taxing blow to a minority segment of ETNs on Dec. 7. It issued a revenue ruling declaring that the income from single-currency ETNs must be accrued during the contract period (versus at the end of the contract as ETN providers had assumed) and is taxable to investors as ordinary income. All three of Barclays' currency ETNs are affected by this ruling.

The IRS also announced that it would seek industry commentary and suggestions on how to tax other categories of ETNs, namely those that track to equity and commodity indexes. That announcement sparked speculation that more ETN tax guidelines are in the wings.

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