How Daily Resetting 300% Inverse Leveraged ETNs May Perform in Bull, Bear and Volatile Markets

For those investors that are bearish, certain MicroSectors daily-resetting inverse leveraged Exchange-Traded Notes (ETNs) may offer investors the ability to participate in 300% of the inverse daily return of specific indices, before taking into account fees and expenses. Sophisticated investors that have a bearish view may consider a 300% inverse leveraged daily-resetting ETN to receive a positive gain that is triple the daily loss of the benchmark index. This article provides an overview of how these products perform in different environments.

Inverse leveraged ETNs may be a suitable investment for you if:

  • You seek a short-term investment with an upside return linked to a three times leveraged participation in the inverse performance of the applicable index, compounded daily.
  • You believe the level of the index will decrease in the short term.
  • You understand (i) leverage risk, including the risks inherent in maintaining a constant three times daily inverse leverage, and (ii) the consequences of seeking leveraged investment results generally.
  • You are a sophisticated investor, understand path dependence of investment returns and you seek a short-term investment in order to manage daily trading risks.
  • You are willing to accept the risk that you may lose some or all of your investment, especially if the level of the underlying index increases.

Inverse leveraged ETNs may not be a suitable investment for you if:

  • You believe the level of the index will increase in the short term.
  • You do not seek a short-term investment with a downside return linked to a three times leveraged participation in the inverse performance of the applicable index, compounded daily.
  • You do not understand (i) leverage risk, including the risks inherent in maintaining a constant three times daily inverse leverage, or (ii) the consequences of seeking leveraged investment results generally.
  • You are not a sophisticated investor, do not understand path dependence of investment returns or you seek an investment for purposes other than managing daily trading risks.
  • You are not willing to accept the risk that you may lose some or all of your investment.

Hypothetical ETN Performance

The following examples and tables illustrate how daily resetting 300% inverse leveraged ETNs would perform over a period of five trading days in different circumstances. They are intended to highlight how the return on the ETNs is affected by the daily performance of the applicable index, leverage, compounding and path dependency, before product fees and expenses.

The resetting of the leverage on each day is likely to cause each note to experience a “decay” effect, which is likely to worsen over time, and will be greater the more volatile the level of the index. The “decay” effect refers to a likely tendency of the notes to lose value over time. Accordingly, the notes are not suitable for intermediate- or long-term investment, as any intermediate- or long-term investment is very likely to sustain significant losses, even if the index depreciates over the relevant time period. Although the decay effect is more likely to impact the return on the notes the longer the notes are held, the decay effect can have a significant impact on the note performance even over a period as short as two days.

The notes are suitable only for sophisticated investors. If you invest in the notes, you should continuously monitor your holdings of the notes and make investment decisions at least on each trading day.

All the examples assume that the notes were purchased on day 0 at an indicative note value of $50 and disposed of on day five at the applicable indicative note value, and that no market disruption events occurred. For ease of analysis, all values have been rounded to two decimal places, and no product fees or expenses were included in the calculations. (In contrast, an actual exchange traded note will have fees built into the product that would reduce the indicative note value and an investor's return.)

In each example, the “Note Return” is the change in the Closing Indicative Note Value from Day 0 to Day 5.

Hypothetical Examples

Example #1: The index level alternatively decreases then increases by a constant rate of 3.00% per day, with the index level decreasing by -3.17% by day five and with a note return of 7.24%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: 7.24%
Cumulative Index Return: -3.17%
Final Indicative Note Value: $53.62

Example #2: The index level increases by a constant 3.00% per day, with the index level increasing by 15.93% by day five and with a note return of -37.60%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: -37.60%
Cumulative Index Return: 15.93%
Final Indicative Note Value: $31.20

Example #3: The index level deceases by a constant rate of -1.00% per day, with the index level decreasing by -4.90% by day five and with a note return of 15.92%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: 15.92%
Cumulative Index Return: -4.90%
Final Indicative Note Value: $57.96

Example #4: The index level decreases in a volatile manner, with the index level decreasing by -13.32% by day five and with a note return of -22.50%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: -22.50%
Cumulative Index Return: -13.32%
Final Indicative Note Value: $38.75

Example #5: The index level increases and decreases in a volatile manner, with the index level ending at the same level.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: -64.20%
Cumulative Index Return: 0.00%
Final Indicative Note Value: $17.90

Are Inverse Leveraged ETNs right for everyone?
No – inverse leveraged ETNs are not intended for all investors. Due to the riskiness of these products, the complexity of daily resetting leverage, the nature of path dependency and the fact that these investments are meant to be held for short-term periods, sometimes less than a single day, these investments are not for everyone. Inverse leveraged ETNs are designed to magnify the inverse performance of a particular index on a daily basis. For example, a 300% inverse leveraged daily resetting ETN linked to an index that increases 3% in a single day could potentially result in a 9% loss to investors before fees and expenses. The ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. Only sophisticated investors who understand daily resetting ETNs and their risks should consider investing.

* * *

Please consider the following additional information about ETNs that is set forth in the links below

Additional Important Information:
Daily resetting inverse leveraged ETNs may underperform in a positive trending performing market, outperform in a negative trending market, and depending on the volatility and index performance in a volatile market, outperform or underperform alternative investment strategies. Accordingly, the notes are not suitable for intermediate- or long-term investment, as any intermediate- or long-term investment is very likely to sustain significant losses, even if the index level decreases over the relevant time period. The notes are suitable only for sophisticated investors. If you invest in the notes, you should continuously monitor your holdings of the notes and make investment decisions at least on each trading day.

The exchange traded notes are subject to the credit risk of Bank of Montreal, the issuer of the ETNs. The ETNs are also subject to the issuer’s credit ratings, and the issuer’s credit spreads may adversely affect their market value.

Inverse leveraged ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. They are designed to achieve their stated investment objectives on a daily basis. The returns on the ETNs over longer periods of time can, and most likely will, differ significantly from the return on a direct long or short investment in the index. Investors should carefully review the applicable offering documents for an ETN prior to making an investment decision.

Bank of Montreal, which participated in the preparation of this article, and is the issuer of ETNs described on REX's website, has filed a registration statement (including a pricing supplement, a product supplement, a prospectus supplement and a prospectus) with the Securities and Exchange Commission (the “SEC”) about each of the offerings to which this free writing prospectus relates. Please read those documents and the other documents relating to these offerings that Bank of Montreal has filed with the SEC for more complete information about Bank of Montreal and these offerings. These documents may be obtained without cost by visiting EDGAR on the SEC website at www.sec.gov. Alternatively, Bank of Montreal, any agent or any dealer participating in these offerings will arrange to send the applicable pricing supplement, product supplement, prospectus supplement and prospectus if you so request by calling toll-free at 1-877-369-5412.


How Daily Resetting 300% Leveraged ETNs May Perform in Bull, Bear and Volatile Markets

For those investors that are bullish, certain MicroSectors daily-resetting leveraged Exchange-Traded Notes (ETNs) may offer investors the ability to participate in 300% of the daily return of specific indices, before taking into account fees and expenses. Sophisticated investors that have a bullish view may consider a 300% leveraged daily-resetting ETN to gain triple the daily return of the benchmark index. This article provides an overview of how these products perform in different environments.

Leveraged ETNs may be a suitable investment for you if:

  • You seek a short-term investment with an upside return linked to a three times leveraged participation in the performance of the applicable index, compounded daily.
  • You understand (i) leverage risk, including the risks inherent in maintaining a constant three times daily leverage, and (ii) the consequences of seeking leveraged investment results generally.
  • You are a sophisticated investor, understand path dependence of investment returns and you seek a short-term investment in order to manage daily trading risks.
  • You are willing to accept the risk that you may lose some or all of your investment.

Leveraged ETNs may not be a suitable investment for you if:

  • You do not seek a short-term investment with a downside return linked to a three times leveraged participation in the performance of the applicable index, compounded daily.
  • You do not understand (i) leverage risk, including the risks inherent in maintaining a constant three times daily leverage, or (ii) the consequences of seeking leveraged investment results generally.
  • You are not a sophisticated investor, do not understand path dependence of investment returns or you seek an investment for purposes other than managing daily trading risks.
  • You are not willing to accept the risk that you may lose some or all of your investment.

Hypothetical ETN Performance

The following examples and tables illustrate how daily resetting 300% leveraged ETNs would perform over a period of five trading days in different circumstances. They are intended to highlight how the return on the ETNs is affected by the daily performance of the applicable index, leverage, compounding and path dependency, before product fees and expenses.

The resetting of the leverage on each day is likely to cause each note to experience a “decay” effect, which is likely to worsen over time, and will be greater the more volatile the level of the index. The “decay” effect refers to a likely tendency of the notes to lose value over time. Accordingly, the notes are not suitable for intermediate- or long-term investment, as any intermediate- or long-term investment is very likely to sustain significant losses, even if the index appreciates over the relevant time period. Although the decay effect is more likely to impact the return on the notes the longer the notes are held, the decay effect can have a significant impact on the note performance even over a period as short as two days.

The notes are suitable only for sophisticated investors. If you invest in the notes, you should continuously monitor your holdings of the notes and make investment decisions at least on each trading day.

All the examples assume that the notes were purchased on day 0 at an indicative note value of $50 and disposed of on day five at the applicable indicative note value, and that no market disruption events occurred. For ease of analysis, all values have been rounded to two decimal places, and no product fees or expenses were included in the calculations. (In contrast, an actual exchange traded note will have fees built into the product that would reduce the indicative note value and an investor's return.)

Hypothetical Examples

Example #1: The index level alternatively increases then decreases by a constant rate of 3.00% per day, with the index level increasing by 2.81% by day five and with a note return of 7.24%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: 7.24%
Cumulative Index Return: 2.81%
Final Indicative Note Value: $53.62

Example #2: The index level decreases by a constant -1.00% per day, with the index level decreasing by -4.90% by day five and with a note return of -14.12%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: -14.12%
Cumulative Index Return: -4.90%
Final Indicative Note Value: $42.94

Example #3: The index level increases by a constant rate of 1.00% per day, with the index level increasing by 5.10% by day five and with a note return of 15.92%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: 15.92%
Cumulative Index Return: 5.10%
Final Indicative Note Value: $57.96

Example #4: The index level increases in a volatile manner, with the index level increasing by 11.66% by day five and with a note return of 32.16%.

Assumptions
Principal Amount: $50.00
Initial Index Level: 100.00
Note Return: 32.16%
Cumulative Index Return: 11.66%
Final Indicative Note Value: $66.08

Are Leveraged ETNs right for everyone?
No – leveraged ETNs are not intended for all investors. Due to the riskiness of these products, the complexity of daily resetting leverage, the nature of path dependency and the fact that these investments are meant to be held for short-term periods, sometimes less than a single day, these investments are not for everyone. Leveraged ETNs are designed to magnify the performance of a particular index on a daily basis. For example, a 300% daily resetting ETN linked to an index that declines 3% in a single day could potentially result in a 9% loss to investors before fees and expenses. The ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. Only sophisticated investors who understand daily resetting ETNs and their risks should consider investing.

* * *

Please consider the following additional information about ETNs that is set forth in the links below

Additional Important Information:
Daily resetting leveraged ETNs may outperform in a positive trending performing market, underperform in a negative trending market, and depending on the volatility and index performance in a volatile market, outperform or underperform alternative investment strategies. Accordingly, the notes are not suitable for intermediate- or long-term investment, as any intermediate- or long-term investment is very likely to sustain significant losses, even if the index appreciates over the relevant time period. The notes are suitable only for sophisticated investors. If you invest in the notes, you should continuously monitor your holdings of the notes and make investment decisions at least on each trading day.

The exchange traded notes are subject to the credit risk of Bank of Montreal, the issuer of the ETNs. The ETNs are also subject to the issuer’s credit ratings, and the issuer’s credit spreads may adversely affect their market value.

Leveraged ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. They are designed to achieve their stated investment objectives on a daily basis. The returns on the ETNs over longer periods of time can, and most likely will, differ significantly from the return on a direct long or short investment in the index. Investors should carefully review the applicable offering documents for an ETN prior to making an investment decision.

Bank of Montreal, which participated in the preparation of this article, and is the issuer of ETNs described on REX's website, has filed a registration statement (including a pricing supplement, a product supplement, a prospectus supplement and a prospectus) with the Securities and Exchange Commission (the “SEC”) about each of the offerings to which this free writing prospectus relates. Please read those documents and the other documents relating to these offerings that Bank of Montreal has filed with the SEC for more complete information about Bank of Montreal and these offerings. These documents may be obtained without cost by visiting EDGAR on the SEC website at www.sec.gov. Alternatively, Bank of Montreal, any agent or any dealer participating in these offerings will arrange to send the applicable pricing supplement, product supplement, prospectus supplement and prospectus if you so request by calling toll-free at 1-877-369-5412.


General Insights

Pure “Big Tech” Exposure With 300% Leverage

The evolution of technology benchmarks
Although the FAANG group of stocks – Facebook, Apple, Amazon, Netflix and Google (now Alphabet) – have a proven track record of innovation and growth, it can be challenging to obtain exposure to these companies in a single trade.

Historically, and prior to sector indices becoming as widely used as they are today, investors looked to broad indices like the Nasdaq-100 Index for a diversified exposure that included some technology holdings. Yet the Nasdaq-100 Index also held companies like Pepsi, Comcast, Starbucks and Costco, which made it potentially unsuitable for investors seeking exposure to a pure “big tech” index. Eventually, and with the help of the Global Industry Classification Standard (GICS®) to identify technology stocks, the industry moved toward more targeted benchmarks, such as the Technology Select Sector Index.

The trouble is that GICS fundamentally changed the way public companies were categorized. When S&P and MSCI updated their classification rules in September 2018, it meant that most internet-related companies were no longer eligible for inclusion in technology focused indices. They would instead be pooled with media and entertainment holdings under the newly designated sector, “Communication Services.” As a result, Visa and MasterCard (which are typically associated with financial services) are currently two of the top five holdings of the Technology Select Sector Index, while four of the five members of FAANG are not included in that index at all.

By contrast, the new Solactive FANG Innovation Index (related ETNs: BULZ, BERZ) offers equally-weighted exposure to 15 of the largest and most highly liquid technology stocks. Looking back at historical returns dating to 2014(1), the Solactive FANG Innovation Index would have outperformed broad market indices, such as the S&P 500® Index and Nasdaq-100 Index.(2)

 

 

Source: Bloomberg, 12/19/2014 – 9/30/2021. See footnote (1) above.

Investors will find eight core components in the Index, picked for their track record of innovation in rapidly growing industries, such as e-commerce, semiconductors, cloud computing and online streaming. There are also seven top-traded additions that are chosen based on market capitalization and trading volumes, meaning that investor demand will influence which holdings constitute nearly half of the portfolio.

Put another away, the index represents a more precise exposure for investors who want pure access to big tech stocks, concentrated in a small number of stocks.

More targeted, greater leverage
What sets the Solactive FANG Innovation Index apart are its related exchange traded products: the daily-resetting 3x leveraged BULZ and 3x inverse leveraged BERZ.

These exchange-traded notes (ETNs) operate under different guidelines than exchange-traded funds (ETFs), which typically need to own a minimum of 20 stocks in order to satisfy certain U.S. 1940 Act and federal tax requirements. The ETN structure can offer investors exposure to as few as 10 stocks; in fact, the ability to link to an index with fewer than 20 names is one of the core advantages of using ETNs versus ETFs.

Due to investors’ growing interest in “Big Tech” companies, and a potentially unmet demand for leveraged solutions, there was a conscious decision to avoid any holdings that could possibly distort the index’s highly focused view of innovation and growth. For example, non-U.S. entities, such as ADRs referencing Chinese tech companies, were omitted despite their size and importance, because these companies have been subject to increasing risks related to U.S. and Chinese government regulation. As another example, a “mega-cap” US software company was included as a core component of the index as opposed to a smaller social media platform company, given that the former has approximately 40 times the market capitalization and a much more substantial track record of growth.

Each of the eight “core” holdings in the portfolio are recognizable, large-cap technology companies domiciled in the United States, with the remaining seven “non-core” components coming from the top traded U.S. technology stocks. These non-core holdings are meant to reflect the potential evolution of investor demand in the market; they are reconstituted quarterly according to trading volumes and may change from time to time. The common thread through the selection process is that the index is designed to include companies building tomorrow’s technology today.

Solactive FANG Innovation Index Constituents:

 

(Index components as of the last rebalance date September 20, 2021)

Conclusion
Ultimately, every technology investor must decide how they want access to their desired amount of technology stock exposure. Ask yourself: will a basket of 70 to 100 securities allow you to express a precise view of the tech sector? Do you want a technology investment that omits Facebook, Amazon, Netflix and Google?

You can dedicate the time and resources needed to buy each stock directly, but that process can be inefficient for active traders who hold securities for days, if not hours. You can choose more traditional benchmarks, such as the Nasdaq-100 Index and the Technology Select Sector Index. Or you can opt for a solution that gives you exposure to some of the world’s biggest technology stocks – with 300% daily-resetting leverage and a focus on leaders in the technology sector.

Learn more about the Solactive FANG Innovation Index and get ongoing access to our expert industry insights by signing up for our newsletter.

Sources:
(1) Historical returns data taken from Bloomberg. The Solactive FANG Innovation Index was launched on June 8, 2021. Index data prior to that date is hypothetical and reflects the application of the index methodology in hindsight. The hypothetical data cannot completely account for the impact of financial risk in actual trading.
(2) Past performance is not indicative of future results.

The exchange traded notes are subject to the credit risk of Bank of Montreal, the issuer of the ETNs. The ETNs are also subject to the issuer’s credit ratings, and the issuer’s credit spreads may adversely affect their market value.

Leveraged ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. They are designed to achieve their stated investment objectives on a daily basis. The returns on the ETNs over longer periods of time can, and most likely will, differ significantly from the return on a direct long or short investment in the index. Investors should carefully review the applicable offering documents for an ETN prior to making an investment decision.

Bank of Montreal, which participated in the preparation of this article, and is the issuer of ETNs described on REX's website, has filed a registration statement (including a pricing supplement, a product supplement, a prospectus supplement and a prospectus) with the Securities and Exchange Commission (the “SEC”) about each of the offerings to which this free writing prospectus relates. Please read those documents and the other documents relating to these offerings that Bank of Montreal has filed with the SEC for more complete information about Bank of Montreal and these offerings. These documents may be obtained without cost by visiting EDGAR on the SEC website at www.sec.gov. Alternatively, Bank of Montreal, any agent or any dealer participating in these offerings will arrange to send the applicable pricing supplement, product supplement, prospectus supplement and prospectus if you so request by calling toll-free at 1-877-369-5412.


3 Trading Advantages of Leveraged ETNs vs. Leveraged ETFs

Daily resetting leveraged exchange-traded notes (ETNs) are a growing niche within the exchange-traded universe. However, they are often mistaken for their more popular cousin – the leveraged exchange-traded fund (ETF).

The problem? The product names sound similar. Both fall within the realm of exchange-traded products (ETPs), which makes them easy to mix up. However, a good rule of thumb to tell them apart is what they can offer. In this article, we discuss three features of leveraged ETNs that help to differentiate them.

1. ETNs can give you specific exposures, with no filler. ETNs can have as few as 10 stock holdings, while ETFs typically need to own a minimum of 20 in order to satisfy certain U.S. federal tax requirements. Let’s say you want to invest in Big Tech. Over the years, many investors used ETFs linked to the tech-heavy Nasdaq-100 Index to obtain access to the tech sector. These ETFs provide access to famous Silicon Valley names, such as Facebook, Amazon and Google. Those titans are in the index – but so are Pepsi, Costco, Starbucks and dozens of other consumer giants. In fact, according to Nasdaq’s website, more than 46% of the Nasdaq 100 Index was weighted towards non-tech industries as of a recent date. Even ETFs linked to a technology focused index, such as the Technology Select Sector Index, may not have the focused exposure on technology leaders that some investors may seek – this index included more than 70 stocks as of a recent date, and omits 4 of the 5 members of FAANG (includes Apple but not Facebook, Amazon, Netflix or Google).

In contrast, ETNs can offer investors access to more narrowly tailored sector-specific baskets. For example, if a sophisticated investor seeks a leveraged ETN that’s linked to an index focused on market leaders in the technology sector, such as the Solactive FANG Innovation Index, they can expect to see only 15 of the largest and most highly liquid technology stocks focused on building tomorrow’s technology, today.

2. ETNs have limited risk of tracking error, even for leveraged solutions. An ETN is a debt security of a bank or a bank holding company, in which the issuer agrees to pay investors according to specified rules, and the performance of the underlying index. Accordingly, an investor's return is contractually linked to the performance of the securities that make up the index. In contrast, when investing in an ETF, an investor faces the potential risk of tracking error, in which the trading price of the ETF may not reflect the leveraged returns contemplated by the fund. For example, in periods of market volatility, the trading price of an ETF may substantially differ from the value of the assets that it holds. In addition, in some periods, such as during March 2020, some leveraged ETFs temporarily elected to, or were unable to, maintain the leveraged exposure contemplated by their fund prospectus.1 Similarly, in recent years, some leveraged funds have elected to permanently change their investment profile to reduce their leverage, for example, from 3x to 2x. These factors can cause the return of a leveraged ETF to differ substantially from an investor's expectations.

3. ETF issuers cannot launch 3x leveraged solutions after February 19, 2021. Another distinct difference is the amount of leverage new ETPs can offer; under Securities and Exchange Commission rules adopted in 2020, ETFs launched today are generally limited to 200% leverage. In contrast, ETNs can offer 300% as an inverse leveraged note or 300% or more as a leveraged note. Accordingly, in order to obtain the 3x leveraged exposure to new and innovative indices that an investor may seek, an ETN may be needed. REX Shares is constantly surveying the market for opportunities to create novel indices which issuers can use to create innovative new ETNs. Because as football legend Bill Parcels once said, “The best ability … is availability.”

The Bottom Line
Sophisticated traders interested in leveraged or leveraged inverse trades are likely to obtain more precise exposures, with less tracking error risk, through an ETN. Learn more about leveraged ETNs and get ongoing access to our expert industry insights by signing up for our newsletter.

Sources:
1 See, for example, Direxion Daily Gold Miners Index Bull 3X Shares and Direxion Daily Junior Gold Miners Index Bull 3X Shares Underexposed at 3/26/2020 Market Open, Direxion Press Release; March 26, 2020.

Leveraged ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks as part of an overall diversified portfolio. They are designed to achieve their stated investment objectives on a daily basis. The returns on the ETNs over longer periods of time can, and most likely will, differ significantly from the return on a direct long or short investment in the index. Investors should carefully review the applicable offering documents for an ETN prior to making an investment decision.

Bank of Montreal, which participated in the preparation of this article, and is the issuer of ETNs

described on REX's website, has filed a registration statement (including a pricing supplement, a product supplement, a prospectus supplement and a prospectus) with the Securities and Exchange Commission (the “SEC”) about each of the offerings to which this free writing prospectus relates. Please read those documents and the other documents relating to these offerings that Bank of Montreal has filed with the SEC for more complete information about Bank of Montreal and these offerings. These documents may be obtained without cost by visiting EDGAR on the SEC website at www.sec.gov. Alternatively, Bank of Montreal, any agent or any dealer participating in these offerings will arrange to send the applicable pricing supplement, product supplement, prospectus supplement and prospectus if you so request by calling toll-free at 1-877-369-5412.


General Insights

What are Exchange Traded Notes (ETNs)?

Introduction
Exchange Traded Notes (ETNs) are senior unsecured debt securities that are typically issued by a bank. ETNs are a type of “structured product,” and have a return that is based upon the performance of an underlying index or other underlying asset, such as a basket of stocks.

We have prepared this document to help explain ETNs to investors, and to describe their key terms. We will also compare some features of ETNs to other products, particularly Exchange Traded Funds (ETFs), which are products that may be more familiar to some investors. We also will describe some of the key risks relating to ETNs.

Key Terms of ETNs
Structure: ETNs are the issuer’s senior unsecured debt securities. They are not backed by any specific assets. For example, if an ETN is linked to a stock index, the issuer will not own a pool of the relevant stocks for the benefit of ETN owners. Accordingly, ETNs are subject to the issuer’s credit risk, and changes in the issuer’s credit ratings may affect their market value.

Underlying Asset: Unlike most traditional debt instruments, ETNs do not pay a conventional fixed or floating rate of interest, followed by the repayment of principal at maturity. Instead, the payments on the ETNs are linked to the value of an underlying index or other asset, such as a basket of stocks. Different ETNs are linked to many types of underlying assets, ranging from large-cap to small-cap stocks, U.S. and non-U.S. securities, commodities and currencies. As the value of the relevant underlying asset increases or decreases, so too does the value of the ETN. The payment at maturity (or upon an earlier call or redemption) can be significantly greater than or less than the principal amount.

Payment Formula: The specific payout on an ETN will be set forth in the applicable offering documents. Investors should carefully review that formula to determine if it is consistent with their investment objectives. For example, an ETN may provide a payout that increases or decreases on a one-to-one basis with changes in the underlying asset (subject to fees), or a payout that involves leverage or other different return.

Interest: Most ETNs do not pay interest. However, some ETNs pay a “conditional coupon” that, for example, may be based on the dividend rate of the securities that comprise an underlying index.

Listing: ETNs are listed on a securities exchange and can be bought and sold at market prices during the trading day.

Leverage: ETNs can offer investors terms that include leverage or inverse leverage that resets periodically. Some of the most popular versions of leveraged and inverse leveraged ETNs include daily resetting leverage. That is, investors receive the daily return of the underlying index multiplied by the specified leverage amount. Leveraged and inverse leveraged ETNs involve additional risks. For example, these leveraged, inverse and inverse leveraged ETNs typically seek a return on the underlying index for only a single trading day. Those leveraged and inverse leveraged ETNs are not “buy and hold” investments, and should not be expected to provide the indicated return of the underlying index’s cumulative return for periods greater than a day.

Management: An ETN does not hold or invest in any assets.
Instead, its payments are linked mathematically to the performance of the underlying index or other asset. Accordingly, an ETN does not have any investment manager or investment advisor.

Fees: ETNs involve fees that impact an investor’s returns. Typically, for ETNs that seek to replicate an index, an investor fee will reduce the potential return on the ETNs. In addition, for leveraged and inverse leveraged ETNs, an additional financing fee or similar fee will reduce the potential return on the ETNs. An ETN’s fees will be set forth in the relevant offering documents.

Principal Differences from ETFs
Structure: An ETF is organized as a separate entity. This entity holds the relevant assets that it tracks.

Management: An ETF will have an investment advisor, that makes purchase and sale decisions as to its investments, based upon the strategy set forth in the ETF’s offering documents.

Fees: An ETF will involve fees that result from its structure and operations. For example, a portion of an ETF’s assets will be used to pay the fees relating to its organization and its ongoing management, and commissions relating to its ongoing purchase and sale of the relevant assets. These fees will reduce the potential returns on the ETFs.

Tracking Error: Tracking error is the annualized standard deviation of daily return differences between the total return performance of an ETF or an ETN, on the one hand, and the total return performance of the underlying index on the other hand. An ETF’s or ETN’s total expense ratio is often used as an indicator of future tracking difference. For example, if an ETF charges 1% to track an index, then ETF returns should lag the index returns by 1%. As noted above, both ETFs and ETNs charge fees and expenses that are not applicable to the relevant underlying index or asset, but do impact the returns realized by investors. ETNs provide investors with the ability to gain exposure to an underlying index or asset with only minor tracking error, arising from the fees included in their terms.

For ETFs, on the other hand, a more significant tracking error can exist between the returns of many ETFs and their underlying indices or assets. A few reasons why the more significant tracking error exists with ETFs are:

  • Transaction and Rebalancing Costs: The net asset value of an ETF will reflect transaction and rebalancing costs and fees, such as when securities or other underlying assets are purchased and sold; these costs and fees are not applicable to an underlying index. When an ETF is tracking an index with many securities or illiquid securities, or an index that rebalances frequently by design (such as an equal-weighted index), the ETF will incur greater transaction and rebalancing costs, which will increase the tracking difference;
  • Sampling: To save on costs, an ETF may not invest in all the securities, futures contracts or commodities comprising its underlying index, but instead, may invest in, for example, a “representative sample” of those assets. This sampling may result in an increased tracking difference for ETFs;
  • Timing: When an index rebalances or reconstitutes its components, the changes are instantaneous, based on the index methodology. In contrast, an ETF tracking an index must realign itself with the index, and may not fully replicate the performance of its underlying index due to the temporary unavailability of certain securities, futures contracts or commodities comprising the underlying index. During the time it takes an ETF manager to buy and sell the necessary securities, securities prices may change, creating tracking difference between the index and the ETF;
  • Cash Drag: Some ETFs receive dividend distributions from their underlying securities and distribute them to ETF shareholders. However, ETFs do not distribute these dividends on a real-time basis; instead, they do so periodically. As a result, an ETF may maintain a certain portion of its portfolio in cash or cash equivalents, which may be temporarily reinvested, which results in transaction costs. The cash drag will result in an ETF having slightly different returns than the fully invested index, causing tracking difference.

For ETNs, most of these factors are not applicable. The terms of an ETN promise to the holder a return that is mathematically linked to the return of the underlying index or assets, minus fees.

Diversification: Most ETFs are registered as open-end investment companies (i.e., mutual funds); like mutual funds, they are required by federal tax laws to be diversified. Generally speaking, with respect to one half of the fund’s assets, no more than 5% may be invested in the securities of any one issuer; with respect to the other half, no more than 25% may be invested in the securities of any one issuer. In other words, the minimum diversification a fund could have is 25% of its assets in each of two issuers, and 5% of its assets in each of 10 additional issuers. In addition, if a fund elects to be diversified for purposes of the Investment Company Act (and most do), the requirements are even more stringent than under the tax laws—with respect to 75% of its portfolio, no more than 5% may be invested in any one issuer. Therefore, a majority of ETFs are invested in a minimum of 20 issuers.

ETNs, on the other hand, due to their structure as a debt instrument, are not subject to the same diversification requirement. Instead, ETNs may track equity indexes or baskets with as few as 10 issuers. This allows investors to obtain concentrated “micro” sector exposure.

Tax Treatment and Tax Efficiency: Although the income tax treatment of ETNs can be subject to uncertainty, ETNs are typically treated as prepaid forward contracts for U.S. federal income tax purposes.

Under that treatment, an investor in an ETN that does not pay periodic coupons generally will be subject to tax only when it disposes of the ETN (whether in a sale, a redemption or at maturity). So long as an investor holds an ETN for at least a year, the investor will recognize long-term capital gain or loss upon that disposition. However, an investor in an ETN that pays periodic coupons (including conditional coupons) will be subject to current tax on those coupons, generally at ordinary income rates.

By comparison, an investor in an ETF usually will be subject to tax each year that it holds the ETF. Because ETFs actually hold underlying assets, if an ETF that is taxable as a pass-through entity (most are) sells its assets, or otherwise changes its composition, the ETF holders have to pay any resulting capital gains tax in that year. Additionally, ETFs are required to make yearly income and gain distributions to its investors, which are taxable. A further tax advantage of investing in an ETN is that an ETN is not structured as an entity (such as a corporation or partnership); instead, it is a debt instrument. An ETF, on the other hand, has to be set up as an entity in order to hold the underlying assets. Being formed as an entity can have a number of tax disadvantages. For example, commodity ETFs are typically structured as limited partnerships and hold futures contracts that are taxed annually, regardless of whether the position was bought, liquidated, or simply held. Investors in a commodity ETF will incur taxes simply holding an ETF throughout the year.

ETFs formed to invest in Master Limited Partnerships (MLPs) typically are set up as corporations, which have the disadvantage of being subject to “double taxation.” This means that any income of an MLP ETF will be subject to tax at the entity level, thereby reducing the amount available for distribution to investors (who will then also have to pay tax on the income distributed to them). An ETN tracking those same commodities or MLPs will not have the same disadvantages.

Additional Benefits of ETNs
Ease of Ownership: ETNs are listed on an exchange and can be bought and sold during the trading day. Most ETNs have a market maker that helps to promote their liquidity. A market maker will typically create a two-way market in the ETN, so that when an investor wants to sell the ETN, the market maker will buy it, and vice versa. Access to New Markets, New Strategies: Unlike many ETFs, ETNs can provide, on a cost-effective basis, access to investment strategies that are not easily accessible in many investment products, such as ETNs that offer exposure to commodity and commodity futures, volatility futures, a basket of less than 20 stocks, a basket of stocks concentrated in a single sector, leverage and inverse baskets and replication or strategies with high turnover.

Leverage and Inverse Exposures: Some ETNs promise the return of 200% or 300% of the performance of an index (resetting daily). If the index increases by 1%, then the 200% leveraged ETN would gain 2% and the 300% leveraged ETN would gain 3%, before fees, for that day. Conversely, if the index decreases by 1%, then the 200% leveraged ETN would lose 2% and the 300% leveraged ETN would lose 3%, before fees, for that day.

The inverse is true for ETNs that provide inverse exposure to an index. If the applicable index decreases by 1%, then the -200% inverse leveraged ETN would gain 2% and the -300% inverse leveraged ETN would gain 3%, before fees, for that day. Conversely, if the index increases by 1%, then the -200% inverse leveraged ETN would lose 2% and the -300% inverse leveraged ETN would lose 3%, before fees, for that day.

These ETNs are intended to be daily trading tools for sophisticated investors to manage daily trading risks. They are typically designed to achieve their stated investment objectives on a daily basis.

Replication and Trend-Following Strategies
ETFs have gradually become more advanced, a trend perhaps best evidenced by the introduction of hedge fund replication products. Trend-following strategies are one example. These are investment strategies that, for instance, oscillate exposure between cash and an index of stocks or commodities, or among several asset classes, based on a variety of quantitative/algorithmic momentum factors. However, because these strategies usually require assets to be held for a limited period of time, the after-tax returns can be limited.

Because an ETN is a debt instrument that doesn’t actually hold the underlying assets, investors can avoid incurring short-term capital gains and high turnover costs that pass through to ETF investors as additional fund expenses.

Disadvantages and Risk Factors
All ETNs are subject to risks, which will depend upon a variety of factors relating to the structure and terms. Investors should carefully read the offering documents for any ETN prior to making an investment decision.

Potential Loss of Principal: ETNs do not guarantee any minimum payment at maturity or upon an earlier redemption. Depending upon the performance of the underlying asset, an investor can lose all or a substantial portion of the amount invested in the ETNs.

Credit Risk: Since ETNs are debt instruments, investors are subject to the credit risk of the issuer, and potential default by the issuer. This is the primary difference between an ETF and an ETN: ETFs are mainly subject to market risk (that is, changes in the value of the assets that they hold), while ETNs are subject to both market risk and the credit risk or the risk of default by the issuer.

Call Risk: Unlike ETFs, ETNs are usually subject to the issuer’s ability to call the ETN at any time. The call price is typically based on the then-current value of the underlying asset. This can be particularly detrimental to an investor if the issuer calls an ETN at a time when the investor might suffer a loss.

Issuance and Liquidity Risk: The issuer of an ETN is not required to issue more ETNs to meet investor demand. As a result, the indicative value of an ETN may be substantially different than the price at which an investor can buy or sell the ETN (i.e., a premium or a discount may exist). Additionally, like an ETF, an ETN can be delisted from its exchange under some circumstances. As a result, an investor may be only able to sell an ETN in the over-the-counter market or, and depending on how many ETNs they own, sell the ETNs directly back to the issuer. In both scenarios, there would be a lack of liquidity and performance transparency with respect to the ETN. The liquidity of the market for any ETNs can materially change over their term. There may not be sufficient liquidity to enable an investor to sell the ETNs readily, and an investor may suffer substantial losses and/or sell the ETNs at prices substantially less than their expected value.

Premium Risk: If an investor pays a premium for an ETN over the indicative note value, it could lead to significant losses if the investor sells the ETNs at a time when the premium is no longer present (or if the ETN is trading at a discount), or if the ETNs are called at price that is less than the price the investor paid for the ETNs.

Redemption Risk: Instead of selling the ETNs in the market on an exchange, an investor can redeem the ETNs directly with the issuer. However, an issuer typically requires a minimum number of ETN units (for example, 25,000) to be tendered for a redemption. Due to the minimum number of ETNs and the discretion of the issuer to redeem them, the liquidity of the notes (directly with the issuer) may be limited.

Conflicts of Interest: The issuer of the ETNs and its affiliates may play a variety of roles, and may engage in a variety of transactions that are adverse to an investor’s interest in the ETNs. For example, the issuer and its affiliates may engage in hedging and trading transactions that impact the value of the underlying assets or indices to which the ETNs are linked. The issuer and its affiliates may also engage in business transactions with entities that have securities included in a relevant underlying index. Affiliates of the issuer may also issue research reports that express opinions that are inconsistent with an investment in the ETNs.

Summary Comparison: ETNs vs ETFs: In order to assist readers in understanding the key similarities and differences between ETNs and ETFs, we have provided the following table:

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