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Three ETNs go to the graveyard

(MoneyWatch) With much fanfare, Barclays (BCS) launched 11 new iPath exchange-traded notes (ETNs) on November 30, 2010. The new products provided leveraged long and short exposure to the MSCI Emerging Markets Index; MSCI EAFE Index; Russell 1000 Index; Russell 2000 Index; S&P 500 Index; and the VIX Index.

    However, the fanfare was far more subdued when Barclays announced earlier this month that three of their ETNs -- the iPath Short Extended S&P 500 TR ETN (SFSA), iPath Short Extended Russell 1000 TR Index ETN (ROSA) and iPath Short Extended Russell 2000 TR Index ETN (RTSA) -- were being terminated effective September 14, more than eight years before their scheduled redemptions on November 30, 2020. The terminations were required by the respective prospectuses if the price fell below $10 in the case of SFSA and ROSA and $15 in the case of RTSA.

    How did these ETNs perform? We'll first look at SFSA, which was linked to three times the "no-reset leveraged inverse" return of the S&P 500 Total Return Index. The note's goal was to earn three times the inverse of the S&P 500 on a daily basis.

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    In 2011, the net asset value (NAV) fell 10.6 percent. Its benchmark, the S&P 500 Index, had gained 2.1 percent. Thus, the NAV fell by not three times, but more than five times the gain in its benchmark. Through August 31, the NAV had lost 61.4 percent, while the S&P 500 had gained 13.5 percent, a loss of more than 4.5 times its benchmark.

    ROSA, which was linked to three times the no-reset leveraged inverse return of the Russell 1000 Total Return Index, saw its NAV fall 10.1 percent in 2011, or 6.7 times the gain of 1.5 percent in its benchmark. Through August 31, the NAV had lost 61.9 percent, or three times the gain of 20.7 percent of its benchmark.

    RTSA, which was linked to three times the no-reset leverage inverse return on the Russell 2000 Index, saw its NAV rise by 9.8 percent as its benchmark index fell 4.2 percent, 2.3 times the loss of 4.2 percent in its benchmark. Through August 31, the NAV had lost 42.8 percent, 2.6 times the gain of its benchmark.

    It's important for all investors to fully understand the risks of any investment they hold. In the case of these ETNs, you likely would have had to sift through the 200-plus page prospectuses to see the costs or amount of leverage used in these vehicles.

    It's hard to even understand what role a leveraged, inverse ETN could play in a portfolio. In addition to the risks of these investments, investors were taking the credit risk of the issuer with no additional compensation. There's no credit-risk premium built into the return. In other words, investors in these notes were providing Barclays with a much cheaper source of capital, as well as paying them the large fees embedded in the ETNs, than the market would have otherwise charged them.

    Lending money to a firm at well below the market's required return isn't something a prudent investor would do. One of my 30 rules of prudent investing is to never invest in something when you don't have a full understanding of the costs and risks.

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