At first blush, it seems Barclay’s new ETN+ notes provide a better mechanism for leveraged exposure to an underlying index without the path-dependency concerns of daily-reset, leveraged ETFs. However, it is useful to use an example provided by Barclay’s themselves to highlight a potential problem: the interest on the financed capital compounds.
Let me explain. The ETN+ notes are described using an analogy where an investor who is seeking 200% exposure to an index over time will borrow money equivalent to their original principal. Naturally, they will have to pay interest on the borrowed money. This interest would be paid out of pocket in our analogous example, but with the ETN+ notes, they don’t send you a bill for interest payments; rather, they get tacked on to your original principal owing meaning that the amount financed is always going up. This is an example of compound growth working against you. The longer you hold it, the more difficult it becomes to escape it’s grip.
Barclay’s provides a 246 page pricing supplement to the prospectus on ETN+ notes and one example they provide themselves is as follows:
Suppose you invested in an ETN+ note for 5 years and during that time the underlying index lost an annualized 0.56% (this works out to -2.79% cumulatively). The time period in question is November 7, 2003 to November 7, 2008 and the interest calculated is as it would be determined today (t-bill rate + 0.75%), and the example uses the actual historical t-bill rates during this time. In this scenario, the ETN+ 200% note lost 26.95% and the ETN+ 300% note lost 51.12%.
In a second scenario, from October 20, 2003 to October 20, 2008 the underlying index had an annualized return of +0.72%, or 3.66% cumulative. This time the ETN+ 200% note lost 17.07% and the ETN+ 300% note lost 31.79%.
In a third, more positive scenario, from July 11, 2002 to July 11, 2007 the underlying index had an annualized return of +12.39% (+79.32% cumulative). In this case the ETN+ 200% note gained 139.39% and the ETN+ 300% gained 199.46%.
So you can see, while they avoid the decay due to volatility (path dependency) of a daily reset leveraged ETF, the compounding effect of the accrued interest financing adds a new bogey in its place. If you expect these to return a set +/- 200%/300% less a nominal financing cost to facilitate the leverage, guess again.
More on this tomorrow.
Very interesting. Not something that you normally think about with investing [compound interest]. This is really something that would always be working against you in leveraged investing even when you don’t see it happening directly. Paying an interest bill before you have cashed out your investment has the exact same effect, except you don’t have a different company telling you that the effect is there.
One really interesting question is if this is more cost effective than self arranged leverage especially after tax considerations are taken into effect. Also it would be interesting to know if interest costs can be used to write down your taxes even in this scenario.
Leveraged investing is exceedingly risky, huge upsides (12% ~ 200% gains :) ) and massive downsides (interest and standard stock market risk). What is always important to determine is the factors that add more risk and if there are factors that mitigate risk. Especially when compared to standard investing, leveraged ETFs and self arranged leveraged investing. This is certainly starting to look like a good product with pretty much the expected risks that the product provides (unlike leveraged ETFs with the decay factor).
It sounds like the ETN+ is quite similar to leveraged investing, unless I’m missing something. The difference seems to be that with leveraged investing you pay the interest periodically rather than letting it sit and compound in the ETN+. In principal these two should work out about the same if when buying the ETN+ you take the money that you would otherwise be paying for a leverage loan and invest it in short-term government debt. I can certainly see that most people wouldn’t do this and probably wouldn’t understand that they are losing interest on a debt that is snowballing within the ETN+. Is there some other factor at play here in the comparison of the two approaches?
What happens with the dividends that a S&P500 tracking ETF like SPY would pay. I can’t imagine that there would be a yield, but would the dividends be accounted for in the movement of the ETN, or does the ETN just track the movement of the index? The treatment of the dividends really determines the attractiveness for me. I would be glad to invest in this if it gave me 3 times the return of the S&P500, including dividends. If not, I’d rather lever up with the SPY using borrowed money (which I can borrow for about 1.61% using Interactive Brokers).
Preet I just stumbled onto this other solution for leveraged broad market bull/bear speculation that are called “MacroShares” from Robert Shiller.
Maybe it’s old news, because the few ETFs that used this strategy never took off and eventually closed down, but it sounds like it’s fundamentally a better mouse trap.
The strategy sounds better then normal leveraged ETFs because it will continue to track the market beyond the near term, and it doesn’t have credit risk or hidden counter party risks like these ETNs.