New ETNs Allow Investors to Profit on Market Volatility… or not

UPDATE: THIS WAS AN APRIL FOOLS PRANK!

Gotcha!

Many writers and experts have commented on the proliferation of bad ETFs as manufacturers cash in on the caché of the ETF name. We’ve seen leveraged ETFs, niche sector ETFs, and alternative strategy ETFs pop up and uninformed investors flock to them still. (For the record, I don’t have anything against leveraged ETFs or sector ETFs and the sort, I take issue with uneducated investors/advisors not knowing how to use/sell them properly).

I attended a press conference yesterday on a new company launching some pretty wild ETNs, and ironically I ran into the author of the Canadian Couch Potato blog, Dan Bortolotti. It’s ironic because the couch potato portfolios stress using the most simple, low-cost, broad ETFs and well, keep reading…

If there is an exotic investment strategy out there, there will soon be an ETF conjured up to make it accessible for the masses. Witness the latest offering from a new company out of California which had previously offered turn-key derivative strategies to pension consultants but have now decided to make these strategies available to retail investors through the use of ETNs (exchange traded NOTES as opposed to FUNDs – which means the investments are senior debt issues of the company, the investor only owns a promise from the company to pay out).

This particular strategy, actually a pair of strategies, are essentially straddle strategies. Think of buying a put and a call on the same stock while waiting for a news release. After the announcement, the stock might shoot up or down and either the put or the call will be worth a lot and the other expires worthless. These ETNs are somewhat similar to this…

One ETN will give you a return of +2.5% after fees for one month if the underlying index (the S&P 500) does not increase or decrease more than 5% from the index price at the beginning of the month. Essentially, you will make 2.5% for the month if the market is relatively “flat”, and as such the ticker on this ETN is FLAT. If the index increases/decreases by more than 5% (at any time during the month) then you earn nothing and you get your money back, less the MER.

The other ETN will give you a return of +5% after fees for one month if the underlying index (again, the S&P 500) DOES increase or decrease by more than 5% at any time during the month. In this case, you can earn 5% for the month if the market is “volatile”, and as such this ETN ticker is FAT. If the index doesn’t increase/decrease by 5% then you earn nothing with FAT and you get your money back, less the MER.

Each ETN essentially resets at the end of the month. The MERs for FLAT and FAT are 2.5% and 3.0%, respectively…. PER MONTH. But here is the kicker: creation units will only be issued if there are relatively equal amounts of FAT and FLAT being bought. Why is this important? Because the market will either increase/decrease by more than 5% or not, and in each case the fund company has one winning hand and one losing hand. (I’m relating it to gambling for a reason!)

In either case, the fund company is essentially guaranteed to make a killing. Since the fee on FLAT is 2.5% per month and if you “win” you get 2.5% – they lose no money, but they make 3.0% on FAT – so they are net ahead 3.0%/month when the market is not too volatile.

When the market IS volatile, they pay out 5% since they “lose” on FAT but collect a 3% fee for the month on FAT. This puts them behind 2% BUT also are ahead by 2.5% on FLAT because those investors would have “lost” – meaning they are again ahead by a net of 0.5%/month.

If you think you can time volatility, be my guest and use these. Personally I would rather buy the stock of the company instead. But for those who need a little active management but still want to stick with plain indexing, Dan is actually in the midst of setting up a couch potato portfolio advisory service with an option of some *slight* market timing with the portfolio allocations, but I think he may use some of these ETNs as hedges for his market calls! Sounds interesting, although I think it is tainting the nature of the couch potato philosophy… Check out Dan’s blog for more details, and I would be interested in your comments.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 14 comments
  • Big Cajun Man

    Interesting new site you might want to have a look at:
    http://thebizinsidernews.com/2010/03/31/a-lap-of-the-blogs-2/

    Seems rather similar…

    • Preet

      I don’t remember seeing him at my meeting with Squawkfox…. something isn’t right here… :)

  • Patrick

    I’m convinced these are a bad buy. Can you tell me how I can short them both to make a guaranteed profit?

  • Mark Wolfinger

    Is it possible for MER to be as high as 2.5% per month? Surely not!

    Best regards,

  • Len Currie

    Are these not a ridiculous buy? I mean if I’m thinking the market is going to be flat for 6 months, I buy FLAT.. first month I make 2.5%.. but the next month, it IS volatile, and I lose the 2.5% MER. Then I’m flat after 2 months? I’m sure the math shows a bit differently, but it sounds really ridiculous to me.

    Why not buy a dividend ETF or something.. then if the market goes down – at least you have the dividend coming to you. And if it goes up.. win/win.

    • Preet

      @Len – yes, very ridiculous – as it was an April Fool’s Prank! :)

  • Len Currie

    Well.. the joke is definitely on me! Good one :-) *feels stupid*

  • Brian

    I can’t believe you got a bunch of ping backs from this april fools post! I like how you set it up with Dan, fooled me.

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