Debt Linked to Index ETFs Selling Faster Than the ETFs

Investors increasingly prefer that structured notes link to exchange-traded index funds rather than the benchmarks themselves, as total assets in exchange-traded products topped $1.8 trillion for the year through October.

One-third of the $2.4 billion of notes tied to the Russell 2000 Index and the Morgan Stanley Capital International EAFE and Emerging Markets indexes links to the iShares ETFs of those benchmarks, according to data compiled by Bloomberg. Last year, those ETFs made up less than 30 percent.

Securities that link to ETFs benefit from brand recognition of names such as iShares, said Serge Troyanovsky, head of North American structured product sales at BNP Paribas SA in New York. The familiarity with the ETFs, as well as opportunities for leveraged returns and loss protection, make the notes more popular with investors than the indexes.

“That’s the main reason why people like the ETF as the underlying” more than the index itself, Troyanovsky said.

IShares funds, which are created by BlackRock Inc. (BLK) and are the largest of any ETF brand, made up 39.1 percent of the market for exchange-traded products as of October, down 0.6 percent for the year, according to a report by the company. Assets in ETPs, which include exchange-traded notes, rose 21 percent from last year.

Leverage, Buffer

The biggest offerings for the notes this year all include protection for investors against incurring some losses, according to prospectuses filed with the SEC. Among the note features are limited leveraged gains and yields greater than 10 percent.

“With structured notes, you can fine-tune your investment outlook,” Troyanovsky said.

Goldman Sachs Group Inc. issued the largest offering tied to an equity ETF this year, $45.2 million of 2.5-year notes linked to the iShares MSCI Emerging Markets Index Fund. (EEM) The notes, sold May 4, yield 1.37 times the gains of the index, with returns capped at 42.2 percent, as long as the fund’s value doesn’t fall more than 20 percent, according to a prospectus filed with the U.S. Securities and Exchange Commission. Investors can lose all of their investment if the ETF plummets.

The iShares MSCI Emerging Markets Index Fund has $38.5 billion of assets, the MSCI EAFE Index Fund has $36.6 billion and the Russell 2000 Index Fund has $14.1 billion as of Nov. 19, according to Morningstar Inc. (MORN) The three ETFs are among the top 10 most traded in October. The MSCI EAFE Index has 921 members based in Europe, Australia, Asia and Israel.

Highest Selling

The securities linked to the iShares funds are the highest selling among notes tied to ETFs of stocks, Bloomberg data show. Banks sold $157.8 million of notes tied to the MSCI EAFE Index ETF, $185.7 million of notes linked to the Russell 2000 Index ETF, and $451.8 million of notes tied to the MSCI Emerging Markets ETF. The next highest-selling was $94 million of notes linked to the SPDR S&P 500 ETF Trust, a fund issued by Standard & Poor’s that replicates the S&P 500 Index.

Investors who buy structured notes linked to ETFs probably aren’t comfortable with the underlying indexes and are unable to replicate the strategies using the options market, said Timothy Strauts, ETF analyst for Morningstar Inc.

ETFs are backed by assets in an underlying basket of securities, typically an index, and ETNs are unsecured bank debt supported by their issuer’s credit and tied to the value of an index or an asset. Providers of ETFs and ETNs create and redeem a set number of shares based on investor demand, and their prices usually track the indexes to which they’re linked.

Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

To contact the reporter on this story: Kevin Dugan in New York at kdugan4@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

Bloomberg reserves the right to edit or remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.