Risk: Simple as ONN, OFF

NEW YORK ( TheStreet) -- There have been several themes of product development in the ETF industry in the last couple of years including funds that offer hedge fund-like exposure as a means of trying to offer portfolio protection. Along these lines there have been many products targeting some aspect of going long or short volatility to allow for hedging or speculation.

The latest products in this space are the UBS ETRACS Fisher-Gartman Risk On ETN ( ONN) and the ETRACS Fisher-Gartman Risk Off ETN ( OFF). The names Fisher and Gartman are for the designers of the indices underlying the funds, Mark Fisher and Dennis Gartman. As the funds' names imply, ONN is structured to do well during so called "risk on" trading environments and OFF is structured to do well during so called "risk off" environments. Many market participants will be aware that the recent volatility in the markets has been bifurcated into risk-on when the market is going up and the most volatile assets outperform and risk-off where the most volatile assets get hit hard as capital flees to investments perceived to be safer. The funds will each have 35 positions and charge a 1.15% expense ratio.

The two funds are essentially mirror images of each other. For example ONN will target a short position in 10-year U.S. T-Note CBOT Listed Futures of 16% while OFF will go long 10-year U.S. T-Note CBOT Listed Futures with a target weight of 16%. ONN will be long commodities like crude oil, various equity ETFs like Market Vectors Russia ETF ( RSX) and currencies like the Australian dollar and of course OFF will be short these types of exposures in corresponding percentages. OFF will be long things like Japanese yen, Swiss franc and certain sovereign bonds. ONN will be short these "safer" holdings.

Bigger Picture

Zooming out a little, the various funds in this space that have come out over the years have been effective for the most part but also frustrating for investors. They've been effective in that they typically do what they are designed to do. The frustration comes in when investors don't fully understand the specific objective.

An example of this can be seen comparing the S&P 500 Volatility Index ( VIX), known by its VIX ticker symbol and the iPath S&P 500 VIX Short Term Futures ETN ( VXX). VIX is the spot index and VXX targets futures contracts on the underlying spot that expire in three months and there is a huge difference between the price action of the two. Year to date VIX is up 50% while VXX is only up 8.5%. VXX does what is supposed to but anyone not taking the time to fully understand what is intended has been disappointed.

The methodology underpinning ONN and OFF is the result of years of experience in constructing the various long and short exposures. However to be successful, these funds expect things that have worked in the past will continue to work in the future. This might be a good bet, but it might not be.

For example OFF has a 12% long position in 30-year German bund futures. Bund yields are about as low as U.S. yields. Further deterioration in the eurozone, depending on the particulars, could cause a meaningful back up in rates that would cause bund futures to drop in price, all of which could be occurring when investors need the protection that OFF strives to offer. OFF is also long 12% in Japanese yen but with a 220% debt-to-GDP ratio in Japan it is reasonable to question how much longer the yen will be a safe haven. OFF's short position in various energy products could also hurt the fund during the "wrong" type of general market decline.

It is also worth mentioning that ETNs are unsecured debt obligations of the issuer, UBS in this case. A failure at UBS would mean a failure of these two notes.

Both ONN and OFF could very well turn out to deliver as investors would hope but it makes sense to let these funds show how they react to various market environments before buying.
At the time of publication, Nusbaum had no positions in any of the products mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.