Barclay’s (the proprietor of iShares ETFs) has just introduced a new leveraged exchange-traded vehicle known as the ETN+ notes. First, it is important to note that these products are not technically ETFs, but ETNs. ETN stands for Exchange-Traded Note as opposed to ETF which stands for Exchange-Traded Fund. An ETN is a debt obligation of the issuer whose value is based notionally on some underlying index, strategy or specified portfolio. In other words, the ETN does not hold the underlying holdings directly, it is just a promise by the issuer to be valued accordingly. This means that if the issuer goes under, you own squat, whereas with an ETF you would actually hold the underlying investments. But, that out of the way, let’s look closer at these new leveraged ETNs.
One of the main criticisms of leveraged ETFs was the path-dependency of the returns. I’ve written about this extensively, but I’ll go on the record and let you know I have no problems with leveraged ETFs. I just have a problem with the fact that most people don’t know how they work and people shouldn’t buy what they don’t understand. I’ve used them in my own portfolio quite a bit. Nonetheless, these new ETN+ notes are designed to address how volatility kills the returns of a leveraged ETF. You see, a leveraged ETF is rebalanced daily in order to maintain a certain leverage ratio. This introduces a compounding/decompounding leverage risk which most investors don’t understand. The net effect is that if an index is up 10% over 6 months, the 200% bull ETF and 200% bear ETF could both produce negative returns.
An ETN+ note should be considered as follows: If an investor had $10,000 to invest and wanted 200% exposure to an index, they could just go out and borrow another $10,000 and have $20,000 market exposure. They would have financing costs on $10,000 to drag returns down slightly (for now), but this method would allow them to forget about path-dependency considerations. The market could zig-zag every other day, but the investor’s net return is going to be twice the index’s return less financing costs. This is how the ETN+ notes work.
There is another wrinkle though. While the notes might have an initial target of +200%, or -200% the degree of leverage will change on any given day depending on what happens in the market. So while on day 1, the ratio might be 2-to-1, on day 10 it might be 1.8-to-1. However, this multiplier only matters to you on the day you buy it. If you bought on day 1, you would get 2x the index return (less financing costs and MER). If you bought on day 10, you would get 1.8x the index return for the period you held it (less financing and MER). The multiplier will be published daily by Barclay’s.
I’ll write more about these new ETN+ notes this week. Lots to cover.
Right now, the first ETN+ notes will be:
Long S&P500, 300% to start: BXUB
Long S&P500, 200% to start: BXUC
Short S&P500, 100% to start: BXDB
Short S&P500, 200% to start: BXDC
Short S&P500, 300% to start: BXDD
Will the 200% leveraged version of these ETN+ notes just close up shop if the underlying index goes below 50% of its starting point?
Michael- I may be stealing Preet’s thunder but there are stop-loss redemption mechanisms in place.
Preet- you hit the nail on the head though. You are buying unsecured debt. I will be interested to read your thoughts on borrowing costs.
Very cool investment product. I will be very intrigued to find out all about this product. Borrowing to invest can be expensive for a regular investor (like me) so a product that has that sort of item built in can certainly be interesting to discover about since it could be a useful way of doing the borrow to invest at a much lower cost. I will be waiting to see what risks will be involved with this new product.
@Michael James: Thicken is correct in that there is a stop-loss mechanism, but it is designed to protect the issuer, not the investor. If the unit price falls to $10/unit, then the stop-loss is triggered and investors will get $10/unit. Seeing as how they started at $50, this is a tremendous loss. Effectively, the issuer has an out to terminate the note and the investor will be left scratching their head.
@Thicken – yes, I will touch upon the borrowing costs later this week. It’s not as rosy as it looks on the surface.
@Cam Birch: assuming that investors understand these products, I do see them potentially becoming quite popular for the reasons you suggest.
Preet you do such a great job explaining how things work, the good the bad and all the details.
Have you ever considered taking things into a more personal area? Would you ever share a look back at the holdings / portfolio allocations’s you’ve actually held personally?
Share what kind of ups and downs you’ve experienced? What % return you’ve actually gotten? It doesn’t need to be amounts, maybe even some 20/20 reflections on you’re best moves and biggest mistakes?
It might not be your style, I’m just interest in the real life results and learning experiences along the way.
Cheers