Citigroup's C-Tracks ETNs linked to the Citi Volatility index to be the company's first ETN

By Emma Trincal

New York, Nov. 2 - Citigroup Funding Inc. is readying its first exchange-traded note and has chosen to tap into the increasingly popular volatility trade by using a brand new index created last week as the underlying for the new ETN.

Citigroup plans to price C-Tracks ETNs due November 2020 linked to the Citi Volatility Index Total Return, according to a 424B2 filing with the Securities and Exchange Commission.

The Citi Volatility Index Total Return was established on Oct. 27 by Citigroup Global Markets Inc., an affiliate of Citigroup and the index sponsor. It is published by the Chicago Board Options Exchange.

"C-Tracks Exchange Traded Notes linked to the Citi Volatility Index Total Return is the first exchange-traded note offered by Citigroup Funding Inc. in the U.S.," Oscar Loynaz, head of Americas structuring and packaging, Citi Retail Structured Products, said in an e-mail.

With both the new index and the new product, Citigroup is setting the stage for a competitive race against its two main competitors, who already have volatility-linked notes in the market: Barclays Bank plc and Bank of America Corp.

"The C-Tracks Exchange Traded Notes linked to the Citi Volatility Index Total Return provides investors with an investable means to gain directional exposure to the implied volatility of large-cap U.S. stocks," Loynaz said.

According to the filing, the index methodology combines a daily rolling long exposure to the third- and fourth-month futures contracts on the CBOE Volatility index, also known as the VIX index, with a short exposure to the S&P 500 Total Return index.

The Citi Volatility Index Total Return is designed to produce daily returns more correlated to the VIX index than a portfolio of VIX futures contracts and with a similar magnitude to the daily returns of the VIX index, the prospectus said.

Created to compete

Citigroup will be competing mainly with Barclays, which has successfully sold two big ETNs that give investors access to equity volatility through VIX futures.

The first one, Barclays' iPath S&P 500 VIX Short-Term Futures index ETN, offers exposure to a daily rolling long position in the first- and second-month VIX futures contracts. The second one, Barclays' iPath S&P 500 VIX Mid-Term Futures index ETN, is based on a daily rolling of a long position in the fourth-, fifth-, sixth- and seventh-month VIX futures contracts.

Other volatility-based notes that are not in ETN format already exist in the market. One recent example is Bank of America's $65 million Strategic Return Notes due Sept. 25, 2015 linked to the Investable Volatility index, which the bank priced in September.

The index, created by Bank of America, seeks to reflect changes in the level of forward implied volatility of the S&P 500 index by using market prices of listed S&P 500 options.

Firms have created their own proprietary indexes to provide a measure of market volatility in the equity markets that would be as correlated as possible with the VIX.

But the correlation is far from perfect. The prospectus warned that the "C-Tracks are not linked to the VIX index," stressing that investors should not expect a perfect correlation between the underlying index and the VIX.

"It looks like they're trying to create something that is more correlated to the VIX, but it's not exactly correlated yet," said Todd Salamone, vice president of research at Cincinnati-based Schaeffer's Investment Research.

"One of the biggest difficulties in volatility trading is that the underlying indexes are based on the futures, not on the VIX itself. And futures do not behave exactly in the same way as the VIX. They just don't."

However, Citigroup's structuring executives believe that their volatility index offers a competitive edge.

"Our offering aims to provide higher daily beta to VIX than competitors' products," said Loynaz.

"Historically, the daily beta of our strategy has been about twice that of competitors, which should make it a more efficient hedging strategy by capturing more of the daily movements of the VIX.

"Clients wanted a solution which provides better hedging effectiveness than what is currently provided by competitors, something that captures the magnitude of the VIX moves beyond pure correlation enabling them to allocate less dollars to their hedging strategy."

The hedging edge

Notes linked to volatility indexes, as evidenced by the size of Barclays' iPath ETNs, have become increasingly popular. The total amount of the iPath S&P 500 VIX Short-Term Futures index ETNs is now $17 billion.

Strategies in which investors are long volatility are viewed as a hedge against a potential market correction since stocks and volatility are negatively correlated.

"There's an increased demand for hedging," said Salamone. "I've heard recently that 65% of institutions are planning on increasing their options exposure.

"A lot of institutions are putting on the protection-type of trade."

Volatility-based strategies in general have become more favored as they allow equity investors to protect themselves from volatility rises while benefiting from it at the same time, explained Salamone.

"They're looking to leverage spikes in volatility enough to compensate in any loss on their long equity positions," he said.

Salamone said that institutional investors are very inclined to use those strategies. But he was more doubtful about how popular they might be among retail investors.

"I don't know if individual investors are necessarily familiar with the concept of volatility," he said, adding that he was not convinced that investors in Barclays' VIX ETNs were mainly retail investors.

The exit door

Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management, said that he was among the skeptics.

"We haven't invested in the concept of volatility play. We're still not sure what the advantages are.

"What's important to us is to make up our mind whether we want to be in the market or not.

"If it makes sense to be in, what are the segments you want to be in?

"One of the goals of those volatility trades is to make money in a down market.

"We're looking to preserve capital in a down market. So being long volatility is not the way we typically think."

The securities (Cusip: 17316G727) are expected to price in November.

Citigroup Global Markets Inc. is the underwriter.

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