Exchange-Traded Notes Cool the Volatility

I have written several articles about closed-end funds that actively manage covered-call strategies. In general, they offer lower volatility and much higher yields than the broad market.

I have been hoping that an ETF that truly mimics the CBOE Monthly BuyWrite index, the closed-end funds that are actively managed, would come to the market, and now one has. Sort of.

Barclays (BCS - commentary - Cramer's Take) just launched a product that comes close to a truly indexed product: the iPath CBOE S&P 500 BuyWrite Index ETN (BWV - commentary - Cramer's Take). You probably know that "ETF" stands for "exchange-traded fund." "ETN" stands for "exchange-traded note." There are differences between the two.

ETN vs. ETF

An ETN does not own the underlying stocks or commodities or whatever is being mimicked. ETNs synthesize the exposure and, technically, are considered debt instruments of Barclays. They rely on Barclays' ability to pay off the debt at maturity, which, in BWV's case, is May 28, 2037. Barclays is a double-A credit, so the likelihood of a default is very low, but if Barclays were to fail, BWV could fail, too.

In talking to an industry source, I was told Barclays had to go the debt route for this product because there are restrictions on using options within an ETF. Barclays is using the ETN structure because it feels this will be the best way to create the effect.

Source: Barclays

This chart tells the story: Returns may lag or exceed the S&P 500, but the highs and lows are less dramatic. An entire portfolio like this is not ideal, but I do believe there is a place for some exposure, as I have written previously.

The most important difference between BWV and the closed-end funds is that BWV, because of the ETN structure, will not have a dividend payout. The yield will accrue to the fund's net asset value but will not pay out. Many investors will be turned off by only getting "half the effect," below market volatility, but no dividend.

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At the time of publication, Nusbaum had no positions in the stocks mentioned, but Barclays is a client holding, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.