UCO belongs to the family of leveraged oil-focused exchange-traded funds (ETFs).
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What is the purpose of exchange traded notes?
ETFs (exchange-traded funds) have been available since 1993, and they are undeniably popular with investors. Despite their similar sounding names, exchange-traded notes (ETNs) are not the same as exchange-traded funds (ETFs), and they come with some significant risks to consider.
While ETNs and ETFs are commonly lumped together, ETP stands for exchange-traded product and encompasses both.
A basket of securities, such as stocks, bonds, or commodities, makes up an exchange-traded fund (ETF). It’s comparable to a mutual fund in many ways, but it trades like a stock on an exchange. The fact that ETFs and mutual funds are legally distinct from the companies that manage them is a key feature. They’re organized as “investment firms,” “limited partnerships,” or “trusts,” respectively. This is significant because, even if the ETF’s parent company goes out of business, the ETF’s assets are wholly distinct, and investors will continue to own the assets held by the fund.
ETNs (exchange-traded notes) are unique. An ETN is a bond issued by a large bank or other financial institution, rather than a pool of securities. 1 That corporation offers to pay ETN holders the index return over a set length of time and to refund the investment’s principal at maturity. However, if something occurs to that company (such as bankruptcy) and it is unable to keep its commitment to pay, ETN investors may be left with a worthless or much less valuable investment (just like anyone who had lent the company money).
Another significant distinction between ETFs and ETNs is that, unlike ETFs, ETNs are not governed by a board of directors entrusted with protecting investors. Instead, the issuer makes all decisions regarding the management of an ETN based on the regulations outlined in the ETN’s prospectus and pricing supplements. In some situations, ETN issuers may engage in proprietary trading or hedging in their own accounts that are detrimental to ETN investors’ interests.
You might question why anyone uses ETNs at all, given that they incur credit risk and are not governed by a board of directors. However, there are a few characteristics that draw some investors to ETNs.
First, there’s no chance of tracking inaccuracy because the issuer promises to pay exactly the return on an index (minus its own expenses, of course). That is, the ETN should be expected to closely track the index’s performance. Of course, well-managed ETFs can achieve the same results, but an ETN comes with a guarantee.
Second, some ETNs claim to give the returns of a certain index that isn’t available through an ETF. An ETN may be the sole choice for investors dedicated to such a specialized investment.
Third, ETNs may have some favorable tax implications. While this may change in the future, ETN investors are typically only required to pay taxes on their investment when they sell it for a profit. Because ETNs don’t pay out dividends or interest like a stock or bond fund, all taxes are deferred and paid as capital gains. It’s worth noting, though, that the IRS has ruled against this tax treatment for currency ETNs, and similar rulings for other forms of ETNs may follow in the future.
Credit risk: ETNs, like unsecured bonds, rely on the creditworthiness of their issuers. Investors in an ETN may receive cents on the dollar or nothing at all if the issuer defaults, and investors should keep in mind that credit risk can alter fast. Lehman Brothers had three ETNs outstanding at the time of its bankruptcy in September 2008. While many investors sold these ETNs before Lehman Brothers went bankrupt (only $14.5 million remained in the three ETNs when the firm went bankrupt), those who didn’t got out got pennies on the dollar. 2
ETN trading activity varies substantially, posing a liquidity risk. Bid-ask spreads can be extremely wide for ETNs with relatively little trading activity. One ETN, for example, had an average spread of 11.8 percent in March 2021! 3
Issuance risk (also known as fluctuating premiums): Unlike ETFs, where the supply of outstanding shares fluctuates in response to investor demand, ETNs are produced solely by their issuers, who are effectively issuing fresh debt each time they generate new units.
Issuers may occasionally be unable to generate new notes without violating bank regulators’ capital requirements.
Furthermore, banks frequently put internal limits on the amount of risk they are willing to take on through ETNs, and issuers have stopped issuing new notes that have grown too huge or too expensive to hedge.
4 Investors who pay a premium for ETNs (in other words, pay more than the note’s value based on the performance of the underlying index or referenced asset) risk losing money if issuance resumes and the premium dissipates, or if the note is called by the issuer and only the indicative value is returned.
Consider one very exotic ETN (TVIX), which was created to track twice the daily returns of a futures contract index based on the implied volatility of the S&P 500 Index. The note’s underwriting bank decided to discontinue issuing new shares of the ETN on February 21, 2012. As additional investors tried to acquire the note, supply couldn’t keep up with demand, and the price began to rise far faster than the note’s indicative value. The ETN’s market price was about 90% higher than its underlying indicative value by March 21. 5 The ETN’s pricing began its dramatic drop back to reality on March 22, 2012, when the underwriting bank declared that it will resume issuing fresh shares. The ETN’s price dropped about 30% in one day and then dropped another nearly 30% the next, concluding the two-day stretch with a price only 7% higher than the fund’s indicative value. 6
Closure risk: An issuer can effectively close an ETN in a number of ways. The note can be called (also known as “accelerated redemption”) by the issuer, who will repay the note’s value less fees. However, not all ETNs contain accelerated redemption terms in their prospectuses or pricing supplements. Issuers can also delist the note from national markets and suspend fresh issuing, which is a considerably less pleasant option. When this happens, ETN investors are faced with a difficult decision. They can either retain the note until it matures, which might take up to 40 years, or they can trade the ETN in the over-the-counter (OTC) market, where spreads are much greater than on national exchanges. Recognizing the potential for investors to be inconvenienced, some issuers have attempted to provide a more note-holder-friendly option by offering to purchase back ETNs directly through tender offers.
We’ve always believed that the credit risk associated with an ETN isn’t worth it. Most investors use exchange-traded vehicles to gain exposure to a certain market segment, not to assess the health of a bond issuer. As a result, ETNs are unlikely to meet their investment objectives.
We’ve lately come to consider that market conditions for ETN issuers may make both issuance and closure risk equally dangerous. The Federal Reserve and the Financial Stability Board regulate the majority of ETNs, which are issued by large banks. The nature of the liabilities that ETNs create on the balance sheets of their bank issuers concerns these authorities. As a result, banks are projected to make significantly less money sponsoring ETNs in the coming years, thus increasing issuance and closure risk for ETN investors.
Is UCO a long-term investment?
UCO, on the other hand, should never be included in a long-term buy-and-hold portfolio; it’s simply too risky, and the fund’s intricacies make it likely to lose money over time, independent of changes in current oil prices, due to the negative influence of contango.
Can I keep UCO ETF for a long time?
UCC is a short-term tactical instrument, not a buy-and-hold investment, because it is a levered product with daily resets. As a result of daily compounding, long-term returns may differ significantly from those of the underlying index.
Is UCO a decent exchange-traded fund (ETF)?
UCO is a geared instrument with a one-day holding duration; it is not suitable for buy-and-hold investors. Over longer holding periods, daily compounding can cause the fund’s returns to differ significantly from those of the index. UCO is an excellent leveraged energy investment.