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:

• ETN+ Long B S&P 500 (NYSEArca: BXUB), with 3x initial leverage
• ETN+ Long C S&P 500 (NYSEArca: BXUC), with 2x initial leverage

The Barclays ETN+ Short Notes:

• ETN+ Short B S&P 500 (NYSEArca: BXDB), with no leverage
• ETN+ Short C S&P 500 (NYSEArca: BXDC), with 2x initial leverage
• ETN+ Short D S&P 500 (NYSEArca: BXDD), with 3x initial leverage

(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:

1 | 2 |