Monday, March 18, 2013

Barclays' Structured Product Linked to a Basket of ETFs and Indexes

By Tim Dulaney, PhD and Tim Husson, PhD

RISK.net recently posted an article entitled "IWM urges investors to think about risk-adjusted returns" in the structured products portion of their website.  The article describes in detail a Barclays product for which Institute for Wealth Management, LLC (IWM) served as the basket selection agent.  Interestingly, the basket is composed mostly of ETFs, which have been appearing in structured products more frequently as the ETF industry itself has become more mature.  IWM's Matt Medeiros talked about the use of ETFs in structured products as a marketing feature:
So it all comes down to how it's introduced. Most investors are already familiar with ETFs, so a basket of ETFs in a protected strategy like a structured note is a relatively easy thing to introduce to them, and it's been pretty well received.
Given the description of the product, we were able to determine that the particular note is Barclays' Buffered SuperTrack Notes due February 19, 2019 (CUSIP: 06741TNZ6).*  Consistent with the description in the RISK article, the basket consists of ten ETFs (EFA, DBC, XLP, DVY, LQD, EWJ, EEM, XLV, QQQ and TIP) and two indexes -- the S&P 500 and the Russell 2000.  The largest index component is the S&P 500, at 34.5%, and the largest ETF component is the iShares MSCI EAFE Index Fund (EFA), at 9%.   The remaining components range between 3.5% and 8% of the basket.

According to the note's PPM, Barclays Capital receives $2.50 in commissions and  IWM receives $20.00 in compensation as "Basket Selection Agent" for each $1,000 note.  How is Barclays Bank PLC paying for these services?  The answer is that the investor is footing the bill.  From the pricing supplement, Barclays states that IWM's "fee is included in the original issue price of the Notes." Let's look at these notes more closely to see how Barclays prices in the fees.

The notes do not pay interest and have a 34% buffer.  This means that if the basket has decreased by less than 34% from the pricing date to the final valuation date, that investors will be owed at least their original investment.  Investors risk losing at most 66% of their investment (if the basket value decreases to zero) subject of course to Barclays ability to meet their obligations as they become due.

The payout investor's are due at maturity is dependent upon the return on the basket as shown in the figure below.
This note is equivalent to a zero coupon Barclays corporate bond with an embedded European at-the-money put option and a short European out-of-the-money (66% moneyness) put option.  Valuation of the product involves estimating the correlation as well as the volatility of the basket components.  We used three years of historical monthly returns to estimate these correlations.  For the volatility, we used the implied volatility of the longest term options for which there was reliable data available.**

We obtained a valuation of $925.57 for each $1,000 investment in this Barclays note as of the pricing date.  This value -- less than the face value net of stated fees and expenses -- implies that investors are not receiving sufficient compensation for the risk they are bearing by buying this structured product.

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*Barclays also refers to these notes as "Global Medium-Term Notes, Series A, No. E-7755."  This product is slated to be issued tomorrow (February 19, 2013).
**All of the terms were much shorter than six years and as a result this valuation can be seen as conservative (since implied volatility tends to increase with term).

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