Barclays (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 could own squat, whereas with an ETF you would actually hold the underlying investments or get the NAV in cash. 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 on my blog, 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.
Note: this structure does not preclude the possibility of both the ETN+ Long and ETN+ Short both losing money against the underlying index.
There is another wrinkle though. While the notes might have an initial target of +200%, or -200% (other options are available) 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) for the period you hold your investment. 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 Barclays, and is referred to as the participation rate.
I’ll write more about these new ETN+ notes in the future. Lots to cover and discuss.
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
Disclosure: No positions in Barclays' ETN+ Notes.