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Kevin Rich’s Second Act

Kevin Rich’s Second Act

Related ETFs: DBV | DBA | DBC
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Kevin Rich, as much as anyone, is responsible for the existence of commodity-based exchange-traded funds.

As CEO of DB Commodity Services, Rich led the effort to launch the first commodity futures ETF in the U.S.: the broad-based PowerShares DB Commodity Index Fund (NYSEArca: DBC), which currently has over $3.7 billion in assets.

MattHouganColHe followed up with the first commodity sector fund, the PowerShares DB Agriculture Index Fund (NYSEArca: DBA), which currently has over $2.4 billion. Shortly thereafter, the DB product lineup expanded to include currency funds, including the controversial PowerShares DB G10 Currency Harvest ETF (NYSEArca: DBV). The latter is considered by some to be the first hedge fund packaged as an ETF, as it uses a long-short strategy to effectively give investors exposure to the “carry trade.”

Today, the PowerShares DB lineup includes 28 ETFs and ETNs with a total of $10 billion in assets under management. It’s been one of the more successful ETF franchises to develop over the past few years.

So it seemed strange to many earlier this year when Rich resigned his position at DB, and disappeared from the ETF map. Why step aside from a fast-growing business, particularly in an area like commodities, where there were significant challenges to manage?

Last week we got our first hint of an answer when a new filing hit the Securities and Exchange Commission detailing an ETF that will be subadvised by “Rich Investment Solutions.”

Rich, apparently, is going solo. True to form, his first new product promises to be interesting, complex and controversial.

Reverse Convertibles

According to the new filing, the new product will be called the “U.S. Equity Reverse Convertible Index Fund.”

Reverse convertibles are structured products offered by major banks to investors who are looking for high levels of income. Each reverse convertible is unique, but they generally work like this: A bank (say, Citigroup) offers a short-term bond linked to a stock (say, Apple.) Citi agrees to pay investors a high yield—say, 10 percent per year. In exchange, the investor will forfeit all upside in the stock itself.

As part of the deal, the investor will get partial downside protection. If Apple is trading at $200/share, the bond might guarantee that the investor will get their money back if, at the end of the term (typically 3-12 months), Apple is still trading above $160/share.

But if Apple dips below $160/share—called the “knock-in” level—the investor will receive Apple shares (instead of a principal payment) and suffer the full downside loss (minus the yield they received in the interim).

Reverse converts have a controversial reputation on Wall Street, with many thinking they are typically overpriced or too complicated for investors to understand. Indeed, because they are entirely structured products, they can seem a bit odd. Unlike something simple—a bond issued by Apple—the company used as a reference isn’t the one guaranteeing the payment. This is, for all risk management purposes, a Citibank bond. It just happens to have an Apple logo on it.

But still, they are popular: According to the Wall Street Journal, almost $7 billion of “reverse converts” were sold in the U.S. in 2008.

And for investors looking for income, they represent an interesting alternative to high-yield bonds.

The ETF Approach

Rich’s new ETF will take this idea and tweak it to fit into a transparent, index-based format. According to the prospectus, the fund will track the performance of an index that will write “down and in” options each quarter on the 12 most volatile stocks in the S&P 500.

These options will function like miniature reverse convertibles on each stock. That is, each option will have a three-month term, and will be positioned with a “barrier price” equal to 80 percent of the trading price of the stock at the time the option was quoted.

The ETF will receive the income (the premium) from writing the option; in exchange, it will take the downside risk if the stock closed below the barrier price. The goal is to generate a yield of around 10 percent per year.

The prospectus actually does a good job walking through the scenarios:

 

 

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