EQUITY RESEARCH

Equity Linked Strategies | U.S. Derivatives Strategy | August 24, 2011

SPECIAL REPORT
Leveraged Exchange Traded Products: An Update
Leveraged Exchange Traded Products (LETPs)
In response to a renewed interest in Leveraged ETPs (LETPs), we reiterate the main points from our previous report on the subject (Leveraged ETPs: Myths & Reality, 11/17/2009). The AUM in LETP remains high at $35 bn with short and ultra-short LETPs accounting for ~ $22 bn of this. Investors have a choice of two distinct types of leveraged products in the market: daily reset LETPs and static LETPs. The choice depends strongly on the investment view.

Maneesh Deshpande +1 212 526 2953 maneesh.deshpande@barcap.com BCI, New York Rohit Bhatia +1 212 526 0367 rohit.bhatia@barcap.com BCI, New York Ashish Goyal +1 212 526 2771 ashish.goyal@barcap.com BCI, New York

Daily Reset LETPs with leverage L provide L times the daily return of the underling index. However, the multi-day return in general will not equal L times that of the underlying index. The multi-day return will depend on the path of the underlying, and in general for a given return, the daily reset LETP will underperform for a high volatility path and outperform for a low volatility trending path. Static LETPs provide leveraged returns over any multi-day period. The multiday return of static LETPs equals the effective leverage at trade initiation times the return of the underlying except if the LETP drops below a pre-defined threshold and is called at that days NAV. The path dependence in static LETPs is much weaker as compared to daily reset LETPs.

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Daily Reset LETPs need to rebalance at the end of the day (buy or sell the underlying) to be able to offer constant leverage to the daily return of the underlying. Daily reset LETP rebalancing amount = m*(m-1)*Return of Underlying* AUM of LETP. This formula indicates that the rebalancing amount is greater for LETPs with negative leverage (m < 0). Since the direction of the rebalancing flows is the same as that of the move in the underlying, these flows can lead to an increase in the volatility of the underlying. The current AUM of listed LETPs is $35 bn and this translates to end of day rebalancing flows of $1.42 bn if we assume all LETP underlyings move by 1%.

Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 7

Barclays Capital | U.S. Derivatives Strategy: Special Report

SPECIAL REPORT Leveraged Exchange Traded Products (LETPs)

There appears to be renewed interest in leveraged ETPs (Exchange Traded Products) as indicated by the number of queries we have received over the past few weeks. This is likely due to investors desire to express a view on the stretched levels of most assets at the current time. While we have previously published a comprehensive report (Leveraged ETPs: Myths & Reality, 11/17/2009) on this topic, here we briefly re-iterate the main points for convenience.

AUM in Leveraged ETPs has remained high

The current AUM of all listed leveraged ETPs is close to $35 bn. Short and ultra-short ETPs account for roughly $22 bn of this. The current AUM is close to the highest ever over the past two years. New products keep coming to the market and these products remain popular with investors as a means to gain leverage or short exposure. Figure 1: AUM for LETPs is close to $35 bn
37 35 33 31 29 27 25 Jan-10 Mar-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 LETP AUM ($ bn)
Source: Barclays Capital, Bloomberg

Types of Leveraged ETPs

As detailed in our comprehensive report, investors have a choice of two distinct kinds of leveraged products in the market: daily reset leveraged products and static leveraged products. As we discuss below, the choice between these strongly depends on the investment view.

Daily Reset Leveraged ETP

The goal of a daily reset leveraged ETP with leverage L (which can be positive or negative) is to provide L times the daily return of the underlying index. However, the multiple-day return of the LETP in general will not equal L times that of the underlying index. The precise multi-day return of the LETP is path dependent and depends on the realized volatility of the underlying during the period (quantified by our golden rule for leveraged ETPs). For a given underlying return, the LETP will underperform for high
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Barclays Capital | U.S. Derivatives Strategy: Special Report

volatility paths and outperform for low volatility trending paths. Importantly, if the underlying returns to its starting value, the daily reset LETP will always lose money. Thus, in order to invest in these products, in addition to having a view on the future price of the underlying, the investor also needs to have a view on the path it will take to get there. The ideal scenario is if the underlying trends in the right direction.

Static Leveraged ETPs

The goal of a static LETP is to provide leveraged returns over any multi-day period. The actual leverage delivered (the effective leverage) changes with the price of the underlying, but the leverage provided to a buyer is known at initiation and is delivered to the buyer over his holding period. A static LETP stops trading and is called at that days NAV if it drops below a pre-defined threshold. The effective leverage increases if the underlying moves in an adverse direction (up for short ETPs) and drops as the underlying moves in a favorable direction (down for short ETPs). Except for financing costs, the multi-day period return of the static LETP is equal to the effective leverage at trade initiation times the return of the underlying. Of course, this is not true if the knock-out is triggered, so while these products are also path dependent, the path dependency is much weaker as compared to the daily reset LETP. Thus, in order to invest in these products, in addition to having a view on the future price of the underlying, the investor only needs to have a view that the knock-out will not be triggered.

Impact of Daily Reset LETP rebalancing

Daily Reset LETPs need to rebalance at the end of the day (buy or sell the underlying) to be able to offer constant leverage to the daily return of the underlying. Daily reset LETP rebalancing amount = m*(m-1)*Return of Underlying* AUM of LETP. For example, the rebalancing flow for an ultra-short ETP (m = -2) if the underlying moves 5% will be 30% of the ultra-short ETP AUM. The rebalancing formula indicates that the rebalancing amounts for short LETPs are greater than for long LETPs. In Figure 2 we show the percentage of LETP AUM needed to be traded daily for different leveraged ETPs, assuming that the underlying moves 5%. The current AUM of the listed LETPs is close to $35 bn, and this translates to end of day rebalancing flows of $1.42 bn if we assume all underlyings move by 1%. In Figure 3 we show the traded volumes due to rebalancing for different moves in the underlyings. Figure 2 highlights that short LETPs can lead to large rebalancing volumes at close if the underlying experiences a significant move. Since the direction of the rebalancing flows is the same as that of the move in the underlying, this can lead to an increase in volatility of the underlying. For example, if the underlying moves up 5%, then the daily reset ultra long LETP (m=2) will need to buy 10% of its AUM and the daily reset ultra short LETP (m= -2) will need to buy 30% of its AUM.

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Barclays Capital | U.S. Derivatives Strategy: Special Report

Figure 2: Percentage of LETP AUM traded end of day for different leverage factors

Figure 3: Currently LETPs will generate $1.42 bn of end of day flows if they all move by 1%
Volume in underlying needed to be traded ($mn) 8000 7000 6000 5000 4000 3000 2000 1000 0 1% 2% 3% 4% 5%

Leverage of the Percentage of LETP Daily Reset LETP AUM traded for 5% (m) move in underlying 1 2 3 -1 -2 -3
Source: Barclays Capital

0% 10% 30% 10% 30% 60%

Percentage Move in Underlyings

Source: Barclays Capital, Bloomberg

Daily Leveraged LETPs require view on future price AND volatility

The expected return of a daily reset leveraged ETP depends on the expected return and volatility of the underlying. Trending markets with high returns relative to the realized volatility lead to outperformance of LETPs, while mean reverting markets with low returns and relatively high volatility lead to underperformance. Figure 4: Expected outperformance of daily reset 2x LETP for different returns and volatility expectations relative to a static 2x LETP

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Expected Volatility 20% 30% -1.0% -2.2% -0.8% -2.2% -0.2% -1.7% 0.9% -0.7% 2.6% 0.8% 4.7% 2.8% 7.3% 5.2% 10.4% 8.2% 14.0% 11.6% 18.2% 15.6% 22.8% 20.0%

40% -3.9% -4.1% -3.7% -2.9% -1.6% 0.1% 2.4% 5.1% 8.3% 12.0% 16.2%

50% -6.1% -6.4% -6.3% -5.8% -4.7% -3.2% -1.2% 1.2% 4.1% 7.5% 11.4%

Source: Barclays Capital

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Expected Return

Barclays Capital | U.S. Derivatives Strategy: Special Report

Performance of Daily Reset LETPs over the past month

The recent market decline can be broken down into two periods: 1) From 7/22 to 8/11: SPX trended lower, declining in 10 of the 11 business days, leading to daily leveraged LETPs outperforming. 2) Since 8/11: SPX has been much more mean reverting, leading to daily reset LETPs underperforming. In Figure 5 we consider the specific example of a daily reset 2x LETP on SPX. Daily reset LETP outperformed through August 8 as markets trended lower but has underperformed since. Figure 5: Daily reset 2x LETP has outperformed 2x static LETP over the past month but has underperformed since 8/8 as markets have become more mean reverting
2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 25-Jul

29-Jul

4-Aug

10-Aug

16-Aug

22-Aug

Cumulative Outperformance of SPX daily reset 2x LETP

Source: Barclays Capital

Effect of Market Environment on LETP performance

Daily reset LETPs underperform when markets are mean reverting and outperform in trending markets. In Figure 6 and Figure 7 we show the relative performance of daily reset LETPs over static LETPs for different paths of the underlying. Figure 6: Daily Reset LETPs underperform in mean reverting markets
Underlying Days Price 1 2 3 4 5 6 7 8 9 10 11 12 100.00 102.00 97.92 101.84 97.76 101.67 97.61 101.51 97.45 101.35 97.29 101.19 Underlying Return Daily Reset LETP Return 4% -8% 8% -8% 8% -8% 8% -8% 8% -8% 8% Daily Reset LETP Price 100.00 104.00 95.68 103.33 95.07 102.67 94.46 102.02 93.85 101.36 93.25 100.71 Daily Reset LETP Static LETP Cumulative Price Outperformance vs. Static LETP 100.00 104.00 0.0% 95.84 -0.2% 103.67 -0.3% 95.53 -0.5% 103.35 -0.7% 95.21 -0.8% 103.02 -1.0% 94.90 -1.0% 102.70 -1.3% 94.59 -1.3% 102.37 -1.7%

2% -4% 4% -4% 4% -4% 4% -4% 4% -4% 4%

Source: Barclays Capital

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Barclays Capital | U.S. Derivatives Strategy: Special Report

Figure 7: and outperform in trending markets

Underlying Price 100.00 103.00 106.09 102.91 105.99 102.81 105.90 109.08 105.80 108.98 112.25 115.61 119.08 Underlying Return Daily Reset LETP Return 6% 6% -6% 6% -6% 6% 6% -6% 6% 6% 6% 6% Daily Reset LETP Price 100.00 106.00 112.36 105.62 111.96 105.24 111.55 118.25 111.15 117.82 124.89 132.38 140.33 Daily Reset LETP Static LETP Cumulative Price Outperformance vs. Static LETP 100.00 106.00 0.0% 112.18 0.2% 105.81 -0.2% 111.99 0.0% 105.63 -0.4% 111.80 -0.2% 118.15 0.1% 111.61 -0.5% 117.96 -0.1% 124.49 0.4% 131.23 1.2% 138.17 2.2%

Days 1 2 3 4 5 6 7 8 9 10 11 12 13

3% 3% -3% 3% -3% 3% 3% -3% 3% 3% 3% 3%

Source: Barclays Capital

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Barclays Capital | U.S. Derivatives Strategy: Special Report

Analyst Certification
We, Maneesh S. Deshpande and Rohit Bhatia, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report. Important Disclosures The analysts responsible for preparing this report have received compensation based upon various factors including the Firm's total revenues, a portion of which is generated by investment banking activities. For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgibin/all/disclosuresSearch.pl or call 212-526-1072. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. Risk Disclosure(s): Options are not suitable for all investors. Please note that the trade ideas within this report do not necessarily relate to, and may directly conflict with, the fundamental ratings applied to Barclays Capital Equity Research. The risks of options trading should be weighed against the potential rewards. Risks Call or put purchasing: The risk of purchasing a call/put is that investors will lose the entire premium paid. Uncovered call writing: The risk of selling an uncovered call is unlimited and may result in losses significantly greater than the premium received. Uncovered put writing: The risk of selling an uncovered put is significant and may result in losses significantly greater than the premium received. Call or put vertical spread purchasing (same expiration month for both options): The basic risk of effecting a long spread transaction is limited to the premium paid when the position is established. Call or put vertical spread writing/writing calls or puts (usually referred to as uncovered writing, combinations or straddles (same expiration month for both options): The basic risk of effecting a short spread transaction is limited to the difference between the strike prices less the amount received in premiums. Call or put calendar spread purchasing (different expiration months & short must expire prior to the long): The basic risk of effecting a long calendar spread transaction is limited to the premium paid when the position is established. Because of the importance of tax considerations to many options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. Supporting documents that form the basis of our recommendations are available on request. The Options Clearing Corporation's publication, "Characteristics and Risks of Standardized Options", is available at http://www.theocc.com/publications/risks/riskchap1.jsp Barclays Capital offices involved in the production of equity research: London Barclays Capital, the investment banking division of Barclays Bank PLC (Barclays Capital, London) New York Barclays Capital Inc. (BCI, New York) Tokyo Barclays Capital Japan Limited (BCJL, Tokyo) So Paulo Banco Barclays S.A. (BBSA, So Paulo) Hong Kong Barclays Bank PLC, Hong Kong branch (Barclays Bank, Hong Kong) Toronto Barclays Capital Canada Inc. (BCC, Toronto) Johannesburg Absa Capital, a division of Absa Bank Limited (Absa Capital, Johannesburg) Mexico City Barclays Bank Mexico, S.A. (BBMX, Mexico City) Taiwan Barclays Capital Securities Taiwan Limited (BCSTW, Taiwan) Mumbai August 24, 2011 7

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