New ETNs to Track Correlation Levels

R-Squared Advisors, a new fund sponsor, launched three new exchange-traded notes today (April 1, 2010).  The new offerings are the first of what the company calls its “correlation series” of exchange-traded products.  These funds offer a unique ability to ensure portfolio diversification and provide enhanced risk-management tools.

Roger Ramghedt, VP of product development at R-Squared Advisors, said the new offerings are based on the “widely believed concept that the only thing that goes up in times of financial crisis is correlation.  The R-Squared Correlation Series should provide institutions and individual investors alike with the ability to capture that belief with exchange-traded notes.”

Portfolio diversification is based on the premise that various asset classes tend to move independently of each other.  In times of financial crisis, such as the events of the past two years, most asset classes behave in a similar fashion, thus losing their diversification characteristics just when they are most needed.  This problem can be solved by allocating a portion of the portfolio to products that increase in value as correlation values rise.

The new funds are designed to track one-year correlation levels between the major asset classes of US stocks, foreign stocks, bonds, and commodities.  Today’s launch includes: 

R-Squared Daily S&P/EAFE Correlation 2x ETN (RSSE) seeks to track 200% of the daily performance, before fees and expenses, of the one-year correlation (r-squared) between the S&P 500 Total Return Index and the MSCI EAFE Developed Markets Index, priced in US dollars.  From the mid-1990s to the mid-2000s, the one-year correlation between US and foreign stocks ranged from a low of about 0.1 to a high of around 0.55.  However, during the 2009 financial crisis it climbed as high as 0.90.

R-Squared Daily S&P/DJ-UBS Commodities Correlation 2x ETN (RSSC) seeks to track 200% of the daily performance of the one-year correlation (r-squared) between the S&P 500 Total Return Index and the DJ-UBS Commodities Total Return Index.  The correlation between stocks and commodities has historically been extremely low (0.00 – 0.05).  However, it is currently near an all-time high of 0.39.

R-Squared Daily S&P/Barclays Aggregate Bond Correlation 2x ETN (RSSB) seeks to track 200% of the daily performance of the one-year correlation (r-squared) between the S&P 500 Total Return Index and the Barclays Capital US Aggregate Bond Index.  Over the past 20 years, the one-year correlation between US stocks and bonds has averaged 0.10 and ranged from a low of 0.0 to a high of around 0.35.  In 2008, the correlation between this pair reached a peak of 0.27 but did not reach the highs seen in 1994, 1996, and 2003. 

Since these new products are ETNs instead of ETFs, their launch was not prevented by the recent SEC decision to halt exemptive relief requests, which applies only to ETFs and open-end mutual funds.  Additionally, these new ETNs do not employ futures, so CFTC involvement was avoided.  The notes are unsecured senior debt obligations maturing in 2035 and will not pay any dividends.  Each of the three new ETNs will have annual expenses capped at 0.65%.

The underlying correlation indexes used by these products are shifted by +0.1 and multiplied by 100.  Therefore, the indexes have a range of 10 to 110, instead of 0.0 to 1.0 for traditional r-squared measurements.  The purpose of this is two-fold: 1) to avoid a total wipeout of the fund when correlations go to zero and 2) to mitigate the effects of the daily 200% leverage.

As always, investors are advised to fully understand these products and the effects of daily-reset leverage before purchasing.

Disclosure covering writer, editor, and publisher: No positions in any of the securities mentioned because they don’t really exist.  No positions in any of the companies or ETF sponsors mentioned because they don’t exist either.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.