RBS' U.S. Large Cap Trendpilot ETNs mitigate risk, but some say strategy is potentially costly

By Emma Trincal

New York, Dec. 6 - Royal Bank of Scotland NV's U.S. Large Cap Trendpilot exchange-traded notes due Dec. 7, 2040 should appeal to investors who want exposure to U.S. large-cap stocks but with less risk, sources said.

However, the risk-reduction component of the underlying strategy may also dampen the return, a financial adviser said, and the fees may be high, another one added.

The issuer planned to price $4 million of the ETNs on Monday, and the ETNs are expected to be listed on NYSE Arca on Wednesday under the ticker symbol "TRND," according to a 424B5 filing with the Securities and Exchange Commission.

The notes are linked to the U.S. Large Cap Trendpilot index, which was created on Nov. 16 by RBS. Standard & Poor's Financial Services is the index's calculation agent.

Cash or equity

The index uses a systematic trend-following strategy that provides exposure to either the S&P 500 Total Return index or a "cash rate" defined as the yield on a hypothetical notional investment in three-month U.S. Treasuries. The exposure is based on the relative performance of the equity benchmark index on a simple moving average basis, according to the filing.

If the level of the S&P 500 Total Return is at or above its historical 200-index-business-day simple moving average for five consecutive business days, the index will track the S&P 500 Total Return with no exposure to the cash rate until a negative trend occurs.

Conversely, if the level of the S&P 500 Total Return is below the simple moving average for five consecutive business days, the index will then track the cash rate instead of the return on the S&P 500 Total Return and will have no exposure to the equity benchmark until the next positive trend. As of now, the index tracks the S&P 500 Total Return, the prospectus stated.

Top-tier credit

"This is intriguing," said Michael Kalscheur, financial adviser with Castle Wealth Advisors, who said that the product met several criteria he requires when considering an investment for his clients.

"RBS has a very good credit rating, and that's our number-one consideration, especially with an ETN," he said.

Royal Bank of Scotland has an A+ rating from Standard & Poor's.

"Secondly, does it help reduce risk? It absolutely does. It is a risk-reducer, so we would take a look at it to see if it fits our clients' needs."

Kalscheur gave an example: The strategy would have reduced losses for an investor during the credit crisis by switching his investment out of equity into cash in the early part of 2007 and by reinvesting the cash back into the S&P 500 Total Return by the end of 2008.

"It also passes the smell test," added Kalscheur. "I can take it to the client and explain how it works. It's easy to understand. It makes perfect sense."

Lagging

Carl Kunhardt, director of investment management and research at Quest Capital Management, said he would not consider the product because investors may have to give up too much of the upside.

"It sounds like market timing to me. And I don't believe in market timing," he said.

"If you superimpose the S&P 500 and the 200-days [simple moving average] on a chart, you'll see that the stocks will change direction before the average.

"You could easily miss out the uptrends that are below the average while participating in the downtrends that remain above the [simple moving average]. That's because an average is always lagging behind the index. It will take longer for the average to reflect the everyday changes, either up or down.

"The ETN is designed for conservative investors trying to protect the downside. But in order to do that, you're killing the bottoms by giving away the top. The S&P 500 could be taking off for days and you would still be sitting on ...Treasuries," he said.

Kalscheur agreed and said this was "a drawback," although it would not be his main objection.

"You're a little bit late to the rally, and you're behind the curve on the downside. So, yes, that's a drawback.

"But that's the price you pay for reduced volatility. You have to give up something, and you're giving up a little bit of the upside."

Fees and simplicity

Kalscheur said that one of his main "problems" with the offering was cost.

"The strategy is clear-cut. It's ruled-based. Anybody can go to Yahoo and determine automatically when to buy the index and when to go cash. Paying 1% just so that a computer can hit a button is a little bit much," he said.

The annual investor fee is 1% per year when the index is tracking the S&P 500 Total Return, according to the prospectus.

"And the fee for the cash is high compared to the three-month Treasury yield," he said.

The annual investor fee is 50 basis points per year when the index is tracking the cash rate, according to the prospectus.

The current three-month Treasury yield is 12 bps.

Finally, Kalscheur said that liquidity could be a problem for small investors because the minimum repurchase amount for the put option was too high.

The minimum repurchase amount is 40,000 ETNs for any single repurchase, which is the equivalent of $1 million minimum at the stated initial price of $25 per ETN, according to the prospectus.

"For the smaller investor, this would not be appropriate," he said.

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