Two years after their introduction, exchange-traded notes are still relatively unknown even among financial experts, but an increasingly volatile commodities market could alert investors to their hidden potential.

ETNs, which trade daily like stocks and exchange-traded funds, recently attracted modest attention when an ETN shorting gold saw futures prices rise about 14% in two days as gold prices temporarily plummeted.

During the drop, hedge funds and other short-focused money players quickly liquidated their positions to meet margin calls and sent prices plummeting further. Commodities are rebounding, but the sharp drop over several days shook many investors who were counting on commodities to continue their steady climb.

Over the past 35 years, commodities have historically performed poorly and typically break even with inflation, according to the 2008 "Equity Gilt Study" by Barclays Capital, which launched the first ETNs in 2006 as a means of reaching difficult-to-reach asset classes, such as commodities, emerging markets, currencies and other advanced strategies, said Philippe El-Asmar, managing director and head of Investor Solutions, Americas at Barclays.

ETNs offer cost-efficient access to passively managed indexes and are not actively managed, El-Asmar said. The notes take the credit risk to the securing industry, not the replication risk, he said.

Prior to 2006, commodities were available only to institutional investors such as pension plans and hedge funds. "ETNs made them available to institutions and to individual investors," El-Asmar said.

ETNs are also attractive because they are not correlated with other markets, he said.

While commodities have been less volatile than stocks lately, an increasing demand for resources by China and India could alter traditional supply lines, the Barclays Capital study said.

Commodities ETNs can serve to further diversify a portfolio, but shouldn't be the focus, El-Asmar said. A balanced portfolio should have 3% to 7% of assets invested in commodities, with the majority in stocks, bonds and mutual funds, he said. There are about eight or nine providers offering a total of about 40 ETNs, he estimated. Providers include Barclays, Goldman Sachs, Lehman Brothers, Morgan Stanley, Deutsche Bank and Merrill Lynch.

Since 2006, the overall ETN structure has improved slightly, with many ETNs now offer daily rather than weekly redemptions, and some providers offering inverse or leverage ETNs, such as ProShares and Rydex, he said. And the ability to trade daily makes ETNs attractive to both long- and short-focused investors, he said.

"They are viewed by institutional investors, such as hedge funds, as good trading tools to access certain markets quickly," El-Asmar said, and can also be viewed as a long-term investment, right along with exchange-traded funds, which continue to attract assets and new iterations (see related story, page 6).

The ability of ETNs to take short positions means they can respond quickly to market swings by betting against or contrary to trends. Deutsche Bank's Gold Double Short ETN, for instance, gained about 14% on March 18 amid a broad selloff of commodities, including metals, oil and wheat. The ETN saw about 437,000 shares trading hands March 19 as investors scrambled to liquidate their positions.

"Gold and the entire commodity arena were due for a pullback after parabolic rallies over the last six months," said Matt McCall, president of Penn Financial Group LLC. "When a commodity or stock has a powerful move such as the commodities have, it is common for the pullback to be violent. Ideally, you would want to sell before the violent swings occur. However, they typically come out of nowhere and happen very fast."

McCall said ETNs and ETFs are ideal vehicles for short-term and momentum traders because they trade like individual stocks and can be bought and sold throughout the day.

"My long-term view of gold along with other commodities in general remains bullish and would not be trying to play every move up and down. If you are a short-term trader, it is a different story," he said.

The surge in the Chinese economy has meant a sharp increase in global demand for several key commodities, including oil and base metals such as copper, zinc, nickel, lead and tin, according to the Barclays Capital report. China is responsible for 50% of the increase in global energy demand, and the country has now passed the U.S. as the world's largest CO2 emitter.

A growing demand for commodities from India is also a concern. This huge increase in demand could outstrip supplies, leading to escalating prices and damage to the ecosystem, Barclays said. With the global population projected to reach 9.2 billion by 2038, human demands on the earth's resources could put a huge squeeze on available supplies and force prices to increase.

Rising commodity prices will cause global inflation; higher interest rates will lower price/earnings ratios in all markets; and inflationary pressure will increase output, growth and employment volatility, Barclays forewarned.

Barclays concludes that the growth in developing economies will exhaust supplies, and long-term investors should adjust their portfolios to reflect these trends.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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