ETNs to Avoid a Full Bear Market Decline

NEW YORK ( TheStreet) -- In the last month or so, Royal Bank of Scotland ( RBS) jumped into the exchange-traded products market with two ETNs and with plans for more funds relatively soon.

The two new funds are the RBS US Large Cap Trendpilot ETN ( TRND) and the RBS US Mid Cap Trendpilot ETN ( TRNM). The two funds employ the same trend-following strategy but for different indices with the general idea of providing long index exposure when the index is above its 200-day moving average, and providing Treasury price exposure when the stock index is below its 200 DMA. Neither fund will pay interest.

More specifically, the large-cap Trendpilot will replicate the S&P 500 when that index is above its 200 DMA and switch to replicating T-bills five consecutive days after the index breaches its 200 DMA. It will go back to equity replication when the index goes back above the 200 DMA for five consecutive days. The mid-cap Trendpilot will do the same thing for the S&P 400 index, which is a standard mid-cap benchmark. Both funds will charge 1% when they are in equity mode, and 0.5% when they are in Treasury bill mode.

Heeding the 200 DMA as a trigger point for defensive action is what I do for my clients, so I buy into the concept wholeheartedly. In a normal diversified portfolio, going out of equities completely in this type of scenario is not very practical due to tax reasons and the brokerage commissions that would need to be paid. However, the Trendpilot funds avoid both. In a taxable account there is no tax consequence for strategy shifts within the ETNs. There would be a reportable gain or loss upon selling the funds, of course.

The aim of this strategy is to avoid the full brunt of a large bear market decline. Crossovers don't occur at the very top; they occur, in a bear market context, after a gradual rollover in the broad index. The breach that occurred in late 2007 was very characteristic of what this looks like and anyone heeding that warning (I blogged about this on Dec. 13, 2007) avoided a lot anguish over the next 17 months.

Per the RBS back test, the large-cap Trendpilot had a five-year average annual return of 7.9% vs. 2.3% for the S&P 500; for 10 years the Trendpilot averaged 7.2% per year vs. 1.4% for the index. The mid-cap results were less dramatic with the Trendpilot outperforming by 1.57% annualized for five years and 1.92% annualized for 10 years.

The Trendpilot won't protect against a shallow decline. For example, the S&P 500 closed last Thursday at 1299. On that day, the 200 DMA was 1155 so the Trendpilot would not go defensive until five days after dropping 11%. It also will not be able to sidestep a panic like the "flash crash" if it is in equity mode.

RBS is also mulling something similar with gold exposure although that will probably use a shorter moving average.

There is one other point that merits consideration before buying either fund. An ETN is an unsecured debt obligation of the issuer, in this case RBS. If you don't recall, RBS was essentially bailed out by the U.K. government which has roughly an 80% stake in the bank. While this may make buying RBS's common shares unattractive, it is unlikely that the government took its stake with the intention of letting the bank fail. But anyone seeing it otherwise should definitely avoid these funds or any other ETNs that the bank might issue.

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At the time of publication, Nusbaum had no positions in the securities mentioned, 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.

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