Sad Tale Of Non-Reset Leveraged ETN

Leveraged ETFs have big problems with volatility, but it didn't have to be this way.

Late last month I was updating reports in the ETF.com Analytics system when something unusual caught my eye.

It was late on a Thursday afternoon, and I was going through dozens of leveraged and inverse funds that hadn't been updated since last summer—most are so tiny and illiquid that they aren't our highest priority when it comes to updates.

I was on the verge of exhausting the thesaurus of synonyms for "small" and "doesn't trade" when I came to the Barclays Short B Leveraged ETN linked to the Inverse Performance of the S&P 500 TR Index (BXDB).

The mile-long name just screams obscurity. Indeed, BXDB has attracted few buyers, with total assets under $2 million. Also, the ETN's pitiful volume is accompanied by median trading spreads almost 2 percent wide.

I hadn't realized it yet, but this forgotten ETN is built on an idea that could deeply disrupt the leveraged/inverse ETF market—an idea that’s in danger of dying out and really shouldn’t.

Here's what initially gave me pause: The old report, written six months ago, noted that BXDB provided "roughly -500 percent exposure to the S&P 500." To be clear, that’s negative 500 percent.

A leverage factor that extreme is unheard of among the more popular leveraged ETFs and ETNs, which provide, at most, plus 3 or minus 3 times the exposure to their underlying indexes, with daily resets.

What was going on with this fund?

I popped over to Barclays' website to investigate, and found something shocking. The leverage factor had increased since last year, to nearly -12x.

I had to bring this up with the analyst team.

It turned out that my colleague Dave Nadig was well aware of BXDB. In fact, Dave wrote an article about it when it launched in 2009, where he called it "possibly the most complex exchange-traded product ever devised."

BXDB essentially seeks to replicate the performance of a short sale made on the S&P 500. Just like a real short position, the fund doesn't rebalance its exposure to keep daily leverage at -1x. It even accounts for the interest you'd receive on the collateral for your short position, paid at the three-month Treasury-bill rate.

This leads to an interesting mathematical effect: Your leverage is fixed for the life of your position in the fund.

Had you bought BXDB when it launched on Nov. 17, 2009, and sold it one year later, your return would have been -12.02 percent—almost exactly the inverse of the S&P 500's total return of 11.80 percent for the period, with the difference being due to interest and fees.

The fund works the way many investors naively assume daily-reset leveraged and inverse ETFs work, with no worries about compounding and path dependency.

But there's a drawback to this approach: Leverage fluctuates depending on your purchase date. Had you bought the fund on Nov. 17, 2010, one year after launch, the nominal collateral required would have shrunk by 12 percent. Meanwhile, the nominal shares short would have been worth 12 percent more. Your effective leverage would be -1.24x.

That explains how BXDB arrived at the absurd -12x leverage factor we see today.

Leverage steadily increased over the course of the five-year bull market, slowly at first, then not so slowly, as the chart below shows.

Originally, BXDB was part of a suite of five ETNs. Here's the complete list:

• Barclays Long B S&P 500 ETN (BXUB), with 3x initial leverage
• Barclays Long C S&P 500 ETN (BXUC), with 2x initial leverage
• Barclays Short B S&P 500 ETN (BXDB), with -1x initial leverage (the one I discussed above)
• Barclays Short C S&P 500 ETN (BXDC), with -2x initial leverage (Now closed)
• Barclays Short D S&P 500 ETN (BXDD), with -3x initial leverage (Now closed)

Those first two notes—BXUB and BXUC, with 3x and 2x positive leverage, experienced the opposite effect. Their leverage fell as the market rallied, and today they have effective leverage factors of 1.60x and 1.39x, respectively.

The other two, with -2x and -3x inverse leverage—BXDC and BXDD, aren't around anymore. In a real short position, you'll get a margin call once your exposure gets too extreme.

For this suite of ETNs, Barclays simply forces redemption if the value of the notes falls under $10 per share, which works out to a cap of roughly 20x leverage.

The two defunct ETNs were redeemed this way years ago. Barring a sudden correction in the S&P 500, BXDB seems likely to see the same fate in the near future.

In his 2009 article, Dave concluded that this ETN series was based on a cool idea, but was too complex to succeed.

I mostly agree with Dave, but also think that there’s more nuance to the tale of BXDB than Dave may have recognized five years ago.

After all, these notes offer something that’s in clear demand by those wishing to speculate with leverage: long-term predictability.

As long as you know—or think you know—where the underlying index will be at a given point in the future, then you should have a good idea of how your leveraged investment will perform.

Just make sure to check the effective leverage factor first—it's published daily on the fund home page as the "participation rate."

The potential uses aren't purely speculative either.

Imagine a trader needing to hedge out a position in the S&P 500 several weeks or months ahead of time. A leveraged, nonresetting ETF would make this possible without tying up much capital or involving options.

Ultimately, this Barclays ETN series takes the opposite side of the trade-off that daily-reset leveraged ETFs make: It gives up predictable leverage for predictable long-term performance.

It's not objectively better, but it isn't worse either. It's strange that the ETF marketplace has gone so overwhelmingly in the other direction, favoring funds that reset their leverage at the end of every day, to the near exclusion of most alternative strategies.

BXDB and its two remaining siblings don't have a chance to build assets at this point—all three are scheduled to mature in November 2014 and, in any case, their leverage factors have fluctuated far from anything reasonable.

But I don't believe the core idea behind this series is responsible for its stagnation.

The notes themselves may be complex, but their performance is easy to understand. If the market goes up 10 percent over your holding period, the value of your position goes up (or down) 10 percent times x, where x is known ahead of time and doesn’t change for individual investors who buy and hold.

Instead of being a bad idea, I blame poor implementation for the disappointing reception BXDB received.

The ETN wrapper was a poor choice—the series likely would have been more successful if it had been done with standard, open-end funds registered under the Investment Company Act of 1940. To be plain, many investors shun ETNs due to their often-convoluted calculation methodologies and added default risk from the underwriting bank.

Unfortunately, the Securities and Exchange Commission has been reluctant to approve new leveraged ETFs under the 1940 Act, so such an ETF would probably not be feasible today. That was not the case when this ETN series launched in 2009, however.

Moreover, the marketing of the notes has been next to nil. Barclays hasn't done much to educate would-be investors about the note's unusual strategy. BXDB's Web page doesn't list a fee, but it does list an interest rate: "T-bills - 0.40% p.a."

Without poring over the prospectus, who knows what that means? And for that matter, what's a participation rate? Or "index exposure," or a "financing level"?

Non-resetting leveraged ETFs are an interesting idea that has been almost completely neglected by fund issuers.

It's easy to see the appeal of a leveraged fund without any pesky compounding or path-dependency problems, even if it introduces its own issues.

Unfortunately, the concept seems likely to die out when these ETNs mature later this year.

At the time this article was written, the author held no positions in the securities held. Contact Scott Burley at [email protected].