BMO’s REX MicroSectors FANG 3x leveraged ETNs designed for traders, not investors

By Emma Trincal

New York, Jan. 23 – Bank of Montreal priced two new exchange-traded notes, which should grab investors’ attention as they offer long and short leveraged exposure to 10 of the most popular technology stocks.

Except that the new vehicles are not made for mom and pop investors.

“This is not a long-term, buy-and-hold strategy. By nature these leveraged ETNs are not designed for investors. These are for traders,” said a buysider.

The creators of the new vehicles made it plain in the wording of the prospectus:

“The notes 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.”

Two 3x series

Bank of Montreal priced $50 million of 0% BMO REX MicroSectors FANG+ index 3x leveraged exchange-traded notes due Jan. 8, 2038 linked to the NYSE FANG+ index, total return, according to a 424B2 filing with the Securities and Exchange Commission.

The return is three times the leveraged participation in the daily performance of the index.

Additionally, the Canadian bank priced another $50 million of the reverse trade – the BMO REX MicroSectors FANG+ index negative 3x inverse leveraged ETNs. These second issue is nearly identical except for the exposure, which is three times the daily inverse return of the index.

Basket scale

Exchange-traded funds and ETNs have met some success when giving investors access to targeted segments of the market or a sector, a market participant said.

Bank of Montreal is no stranger to this approach. The issuer a year ago priced $310 million of notes linked to Raymond James Analysts' Best Picks for 2017, a repeat deal it prices successfully twice a year, according to data compiled by Prospect News. Bank of Montreal also issued notes linked to specific baskets, such as interest-rates sensitive stocks or oil stocks, in both cases picked by Raymond James.

While the issuer of this ETN is not using a basket, the index is highly concentrated in 10 names.

The NYSE FANG+ index was created last year by ICE Data Services, which is part of Intercontinental Exchange. It consists of 10 highly liquid stocks that represent the “top innovators across today’s tech and internet/media companies,” according to ICE’s website.

It includes the five core “FANG” stocks — Facebook, Apple, Amazon, Netflix and Alphabet’s Google, plus another five actively-traded technology growth stocks — Alibaba, Baidu, NVIDIA, Tesla and Twitter.

Playing momentum

The 10 stocks in the index are extremely popular, noted a buysider.

“I’m actually surprised that it hasn’t happened earlier, because the ‘FANG’ have been the darlings of momentum investors for a while now,” he said.

“People have been buying them because they keep on going up.

“Momentum has a lot of appeal to investors. It’s the way the market operates. I don’t know how successful these products will be but if we see more of those ETFs and ETNs on these FANG, it may perpetuate that momentum trend.”

The use of a concentrated index tracking some of the most active contributors to the tech rally was overdue.

“It’s common sense. People are trading these larger names,” a market participant said.

“Most technology exchange-traded products have anywhere from a 100 names like the “Qs” down to 35 names.”

He was referring to the PowerShares QQQ Trust ETF, which tracks the Nasdaq 100.

“The whole goal is to target a smaller group of stocks.”

Leverage decay

Elliot Noma, founder of Garrett Asset Management, LLC, said that the leveraged exposure in an exchange-traded product makes those investments useful to traders and unsuitable for long-term investors.

“It’s a day-trading vehicle. Those [exchange-traded products] are for trading purposes only. That’s how they’re designed. I don’t think anybody should buy and hold it,” he said.

He pointed to the daily reset of the leverage, which can cause discrepancies between the performance of the notes versus three-times the index.

He explained the daily rebalancing of the notes, a subject he wrote a paper on.

“If the stock is up, you have to buy more stock to keep the three-times exposure the notes are designed to achieve,” he said.

“Same thing for the short leveraged ETN. If the stock is down you have to sell more, otherwise your leverage is going to be diluted.

“In other words, you have to buy at the top and sell at the bottom.

“It’s just the way leveraged ETNs work.”

If the daily reset was not implemented the desired exposure could not be achieved.

“It’s a drag but that’s the way it works out. That’s how the ETNs operate.”

This “drag” also known as “leverage decay” is the reason why those vehicles are not conceived for long-term buyers, he added.

“For day-traders though it’s perfect. You put it on in the morning, take it out in the afternoon. You don’t feel the pain of the reset when you use it intraday.”

There were other benefits.

“Execution is better. The leverage is built in. You don’t have to go on margin. It’s a big advantage especially for people with a very short-term view who don’t want to trade on margin.”

Managing the wins

Wade Slome, president and founder of Sidoxia Capital Management LLC, said that the concentrated index was probably more volatile than a more diversified index such as the Nasdaq 100.

“It allows people to speculate, and possibly to hedge,” he said.

“If it becomes a popular product, if it’s widely traded I may spend more time looking at it.”

One possible use of the new ETNs would be hedging in a tax-efficient way.

“You may have large positions of those stocks in your portfolio with sizeable gains and you may be tempted to take some profit. But rather than sell and incur a taxable gain, you can hedge these stocks with the ETNs.”

Investors in this case could either buy the short leveraged version or short the long leveraged ETN.

Noma said that if he is bearish or alternatively needs a hedge, his preference goes to shorting the long leveraged ETN rather than buying the short instrument.

“It’s a better way to manage volatility,” he said.

Either way, investors can use the notes as a hedge as well as directional bets, sources said.

Pricing

The BMO REX MicroSectors FANG+ index 3x leveraged ETNs are listed on the NYSE Arca under the ticker symbol “FNGU.”

The Cusip is 063679872.

The BMO REX MicroSectors FANG+ index negative 3x inverse leveraged ETNs are listed on the NYSE Arca under the ticker symbol “FNGD.”

The CUSIP is 063679864.

Both series of ETNs are putable under the same conditions. The notes are putable beginning Jan. 26, subject to a minimum redemption amount of 25,000 notes and a 0.125% redemption fee amount.

Both ETNs priced on Jan. 22.

The structuring agent for the ETNs is REX Shares, LLC, a Westport, Conn.-based provider of alternative investments, which designs alternative ETFs. Its chief executive officer, Greg King, co-founded VelocityShares, another exchange-traded fund and ETN provider, now part of Janus Capital. King was also the head of ETF products and marketing at Credit Suisse.

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