Barclays Capital ETN+ Notes: Cool … Or Just Crazy?
November 19, 2009
BarCap’s take on leveraged and inverse is possibly the most complex exchange-traded product ever devised. Is that a good thing?
Here’s the only simple part of this article:
Barclays Capital, the investment banking division of Barclays Bank PLC, is launching a set of five leveraged exchange-traded notes.
The notes―two long and three short―will offer investors exposure to leveraged returns linked to the performance (or inverse performance) of the S&P 500 Total Return Index. Like all ETNs, they have a fixed maturity, with a payout in November of 2014. Because they are ETNs, the pending products are essentially senior, unsecured debt issued by Barclays Bank, meaning the ETNs carry credit risk.
Now it gets interesting. The notes offered are:
The Barclays ETN+ Long Notes:
The Barclays ETN+ Short Notes:
(If you think the product names and leverage amounts are confusing, just wait.)
These ETNs bear very little resemblance to the leveraged and inverse funds currently being used by ETF investors and traders. For the most part, those ETFs provide the one-day return of an index based on some leverage factor. So if the S&P 500 goes up 2 percent in a day, a 2x leveraged S&P 500 ETF would go up about 4 percent.
Those ETFs have worked remarkably well at that prospectus-stated goal. However investor confusion over what the funds were actually intended to do (provide daily returns, not point-to-point returns) created a firestorm of controversy over the last year, as the daily-compounding, path-dependent nature of the ETFs created some forehead-scratching returns conundrums for anyone holding a position for months at a time.
The new BarCap ETN+ products, on the other hand, deliver a pattern of returns completely unrelated to those ETFs. Instead, the new Barclays ETNs will pay out based on "what if" benchmarks, a difference that, in the end, might be their greatest strength.
How It Works
To understand how these work, let's take a look at the simplest product: the 2x long ETN, BXUC. Essentially, BXUC asks the following: Imagine you took $100, then borrowed another $100 and then you invested the whole $200 in the S&P 500: How much money would you have in November 2014?
That’s the pattern of returns BXUC gives you. And it's not as simple as it sounds.
First off, no matter what else occurred, you’d have to pay some set borrowing cost on that borrowed $100. In the case of BXUC, your entire cost of owning the ETN, including Barclays’ fee, is rolled into that financing cost, and in the case of this fund, you’re going to pay the 91-day T-bills yield plus 75 basis points, as specified in the prospectus documents. Right now that comes out to less than 1 percent total.
Second, your “participation” (a key phrase here) in the performance of the S&P 500 is a factor of 2—but only if you bought the ETN on the very first day. Every day after that, your participation is actually increased by your cost of financing - you get a little more leverage every day.
So if the index goes up 25 percent, your initial $200 investment becomes $250—but your claim on that $250 is actually much less: It is $250, minus the $100 you borrowed as well as whatever your accrued cost of borrowing is.
Lastly―and most importantly―all of the above only applies on the very first day. When our index rises 25 percent, we have that $250 working in the market. But now we owe at least the $100 we initially borrowed, so our investment is really worth, at most, $150 (minus the borrowing costs). That’s how much you’d sell it to me for. Of course, if I bought it from you at $150, and I’d only get $250 working the market, my leverage factor would no longer be 2, it would become 1.66. It works the opposite way too.
From the BarCap fact sheet:
In other words, although BXUC started out offering 200 percent exposure to the market, that exposure will literally change tick by tick. Thankfully, BarCap is having Reuters publish a participation “ticker” for every one of these funds, so investors can at least attempt to make an informed investment about how much leverage each product offers.
One final point of order: On each note, Barclays has a stop-loss that allows them to redeem the note should its value drop below $10.
Of course, as if that weren't confusing enough, all this math changes on the short side, where, among other things, investors are credited the T-bill rate, just like short investors reinvesting the proceeds of their short sale.
What’s It All Mean?
Why bother at all? Barclays' new funds do remove the specific path-dependency and daily-compounding issues associated with the current range of leveraged and inverse ETFs—the very issues that have tripped up so many investors in leveraged and inverse funds to date.
However, the ETNs have leverage considerations all their own.
The first critical issue is the scaling of leverage as the market rises and falls, as outlined above. While that may sound like a train wreck, it’s important to understand that these are snapshot changes in leverage. If the implied leverage on the day you buy in is 2x, then regardless of what day you exit the ETN, your experience will always be 2x.
Well, almost. The second critical issue is that the implied financed amount―that $100―never, ever goes down. In fact, it constantly goes up as the financing rate and BarCap’s fee accrues. After all, even if the index stays exactly flat, meaning the $200 remains $200, that $100 financing will go up day after day, both reducing the value of your $100 initial investment, and increasing its implied leverage.
Let’s look at the hypothetical implied returns of the strategy from BarCap’s own 246-page pricing supplement to the ETN (these are all for the 2x long note):
July 11, 2002 – July 11, 2007:
S&P 500: +79.32 percent
Frankly, this is the best-case scenario, and it shows a five-year annualized return of 19.07 percent vs. 12.39 percent for the index―meaning there’s still an implied 5.71 percent lost every year due to the financing costs.
October 20, 2003 – October 20, 2008:
S&P 500: 3.66 percent
This headline-grabbing perfect-storm scenario is ultimately explained by the same problem. While the index remained flat, financing costs have hurt performance by an annualized 3.73 percent a year. That’s enough to take a modest gain and turn it into a pretty big loss over five years, and yet again, it’s simply the cost of borrowing.
Conclusion: Who’s This For?
There are definitely some cool ideas here, but the complexity of the product is likely going to be a big barrier for most investors. Luckily, with daily redemption and a 25,000-lot size, the products will probably avoid the phenomenal spread problems other ETNs have had.
There are issues with the product launch itself. Not only are the products extremely difficult to understand, they’re named very poorly (the B long fund is 3x, but the B short fund is unlevered? But both “C” funds are 2x?). The core documents needed to understand the products are some 250 pages long, but most investors won’t even be able to open up the fact sheets from the Web site, since they’re all contained in PDFs with the same name and no extensions (confounding all but the most die-hard prospectus hunters).
The good news is that while leveraged and inverse ETFs require daily rebalancing to maintain a given level of exposure, the BarCap ETNs won’t. If the participation rate today is 2x, your $100 investment should go up (or down) at twice the rate of the S&P 500, minus the rather significant financing costs, regardless of what day you sell.
But it’s also important to understand that these products will fundamentally change their stripes every single day and become more and more leveraged over time, and there’s simply nothing investors can do about it. If the participation level of “2x” long ETN is actually 1.5 today, no amount of financial shenanigans will get it back up to 2.
Fundamentally, the new ETNs are simply a trade-off: They provide a more viable “fire and forget” leverage experience in exchange for an ever-changing product description. For many investors, this could make them a better mousetrap. Unfortunately, the mousetrap is so complex I imagine even the most in need of the exterminator may settle for the simpler one, even if it’s more likely to snap on their fingers.