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.