On Friday, the first ETNs directly listed in Canada began trading. These were issued by Barclays Bank under their ubiquitous iPath banner. We’re going to have S&P 500 VIX Short-Term Futures hedged in CAD (VIX CN Equity) and S&P 500 Dynamic VIX hedged in CAD (DVX CN Equity) and finally a Pure Beta Crude Oil CAD-Hedged ETN (PBO CN Equity).

On the surface this obviously points to an increasing sophistication of Canadian investors and perhaps the increasing importance of Canada to international firms (just look at how effectively BlackRock swallowed Claymore). But peering a little bit deeper, I grow fearful of the possible effects caused by the ignorance of investors regarding the dangerous nature of these products the moment market conditions become ‘abnormal’. Devastatingly, these products are meant to be used tactically to hedge against such ‘abnormality’.

Reading David Pett’s article in the National Post I was pretty shocked to see the lack of a delineation between the theory and reality of ETNs; he states quite correctly that:

Exchange-traded notes are similar to exchange-traded funds with performance tied to an underlying index.

But unlike ETFs, they are structured as senior debt notes issued typically by a major bank such as Barclays, who are the largest provider of ETNs in the world.

But I freak out when he says very matter-of-factly that:

While ETF returns may differ from the underlying index being tracked, ETNs provide error-free tracking of their underlying indexes minus annual fees.

‘Error-free‘ is quite a dangerous statement to make (and indeed quite a dangerous assumption for investors to make) when the we have observed that there are rather significant errors to be found in these instruments’ tracking.

Two examples are the disconnect that happened a few weeks ago between the Credit Suisse [[TVIX]] instrument and between Van Eck‘s Market Vectors China [[PEK]] and the Chinese A-share index it should be tracking:

Suffice it to say, I believe the false security investors have in the economic reality that is supposedly underpinning these ETNs (be it Credit Suisse’s credit worthiness or the value of a basket of derivatives which have been amalgamated in order to synthetically replicate the movement of an underlying asset) has the potential to cause a significant amount of pain. In investment management, the lower case Greek letter omega ω represents Tracking Error which is a measure of how closely a portfolio (or instrument) follows the index to which it is benchmarked. I have a feeling we will be hearing a lot more about ‘omega’ in the next decade. I’m going to go so far as predicting that shortly we will be seeing a plethora of Omega-Swaps and Omega-Options to protect investors against potential disconnects between the instruments they are using and the indexes they think they are tracking. I will be conducting further research into this throughout the summer.

A valuation easter egg: