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.