[A] stock “ABC” trades at $50 per share at the start of the 90 day period, and a down and in 90 day put was written at an 80 percent barrier (resulting in a strike price of $50 per share and a barrier price of $40 per share) for a premium of $4 per share:

• Settlement above the barrier price: If at the end of 90 days the ABC stock closed at any value above the barrier price of $40, then the option would expire worthless and the Index’s value would reflect the retention of the $4 per share premium. The Index’s value thus would be increased by $4 per share on the ABC option position.
• Settlement at the barrier price: If at the end of 90 days ABC closed at the barrier price of $40, then the option would settle in cash at the closing price of $40, and the Index’s value would be reduced by $10 per share to reflect the settlement of the option. However, the Index’s value would reflect the retention of the $4 per share premium, so the net loss to the Index’s value would be $6 per share on the ABC option position.
• Settlement below the barrier price: If at the end of 90 days, ABC closed at $35, then the option would settle in cash at the closing price of $35, and the Index’s value would be reduced by $15 per share to reflect the settlement of the option. However, the Index’s value would reflect the retention of the $4 per share premium, so the net loss to the Index’s value would be $11 per share on the ABC option position.

Every 90 days, the options included within the Index are cash settled or expire and new option positions are established.

Does This Make Sense For Investors?

The big question is, does this make sense for investors?

First, it’s important to point out that this isn’t really an ETF that invests in reverse convertibles. It’s an ETF that invests in an out-of-the-money put strategy designed to extract the time-and-volatility premiums from the options markets. It just so happens that the pattern of returns could theoretically look like the pattern of returns a dedicated reverse convertible strategy might yield.  It's probably a better strategy than a true reverse convert, avoiding the pricing opacity of traditional reverse converts. But it is important to understand the difference.

Putting aside that the strategy isn’t actually a reverse convert strategy, would you want to be in one if it were?

There is a great deal of negative media coverage of reverse convertibles, and a slew of lawsuits involving investors who did not understand the products they were buying. There are even academic studies showing that reverse convertibles are significantly overpriced; a 2006 study in the Journal of Banking & Finance found a “significant pricing bias in favor of the issuer.”

Still, some say that they offer attractively high yields for yield-hungry investors. In an environment where money market funds are paying 0.15 percent, earning a 10 percent yield may be attractive, even if you take on significant downside risk.

And the advantage of putting reverse converts into an ETF structure is that at least it should make them diversified and fully transparent. Most likely, the ETF’s pattern of return will look like a one-sided hill. It will steadily churn out income with little downside movement, until the market hits a quarter where it falls by 20 percent-plus, some or all of the options “knock-in” and the ETF takes a huge tumble. That’s the risk you’ll take.

And of course, the last risk is credit risk. If the ETF were investing in actual reverse converts, that would be the risk that the issuer (banks like Citi) defaults. In the case of this synthetic version, the risk is that the counterparties to the options (which will mostly be over the counter, not exchange traded) default. How well those counterparties are disclosed remains to be seen.

Clearly, a reverse-converts ETF (whether synthetic, like this one, or a hypothetical real one) is not for everyone. But it does take a product with a significant investor base out of the dark corners of structure product-land and into the light of the ETF world, bringing liquidity, transparency and (I suspect) much lower prices to a corner of the market where banks have long charged huge premiums.

I’m not sure that will make it a success. But it will be interesting.

The prospectus for the new fund is available here.

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