Preet Banerjee's  Instablog

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.

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 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 Barclay’s, 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

The Financial Blogger had asked a bunch of other personal finance bloggers if they wanted to participate in a friendly stock picking contest for 2009. The criteria was to pick four securities in equal dollar amounts listed on a Canadian or American exchange (not including derivatives) to just sit on for the duration of 2009 with no changes allowed. We are to provide updates every quarter and the contest ends on the last trading day of 2009. The initial prices will be based on the closing prices of December 31st, 2008 (i.e. yesterday).

My picks were pure swing for the fence plays - two of them were 300% leveraged ETFs, one was a 200% leveraged ETF and the fourth was a penny stock play. Leveraged ETFs only do well if the underlying investment goes in the intended direction with little to modest retracements (if you are holding them for any extended length of time).

You can read the original rationale for the picks on my original post back on January 1st, 2009.

In case you don’t read the original post, read this: THIS STOCK PICKING CONTEST IS JUST FOR FUN, IT IS NOTHING MORE THAN GAMBLING. DON’T EVEN THINK ABOUT BUYING THE STOCKS LISTED HERE OR ON ANY OF THE OTHER BLOGGERS’ SITES WITHOUT FIRST CONSULTING A PROFESSIONAL FINANCIAL ADVISOR. IF YOU BUY THEM ANYWAYS, YOU MUST RAISE YOUR RIGHT HAND BEFORE PLACING THE ORDER AND REPEAT, “I AM A NUTBAR”.

The second quarter was kind to most equity portfolios and having a significant degree of leverage further enhanced that performance. My four picks were up 50.29% for Q2, after having been grossly underwater in Q1 (-21.77%). The cumulative performance for the first six months of 2009 now stands at +28.52%.

A brief recap of the picks:

1. TNA.us: Direxion Small Cap 3x Shares (-18.54% YTD)
2. EDC.us: Direxion Emerging Markets 3x Shares (+54.95% YTD)
3. ENA.v: Enablence Technologies (+96.67% YTD)
4. HOU.to: Horizons BetaPro Nymex Crude Bull Plus ETF (-19.01% YTD)

On a relative basis I went from 7th out of 9 competitors to 4th out of 9. You can click on the other bloggers’ names below to read their performance updates too. (If they have not yet updated their blogs, you will be directed to their homepages.)

Disclosure: Long EDC, ENA.v