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Stupid Financial Tricks

Stupid Financial Tricks
By Ron DeLegge, Editor
June 18, 2009

SAN DIEGO ( Ė Leave it up to Wall Street to invent financial contraptions that blow up.

Auction-rate securities, exchange-traded notes (ETNs) and collateralized debt obligations (CDOs) are just a few examples of financial instruments that have recently left a hole in investorís pockets. And now, a little known exchange-traded commodity trust could be next.

Letís evaluate this trust and two other stupid financial tricks.

Share Imbalances
As we learned last year, any type of imbalances whether itís in broader financial markets or with individual securities often spells trouble.

This time itís the U.S. Natural Gas Fund (NYSEArca: UNG) with the problem. Investors have been pouring so much money into UNG that itís run out of shares. And unlike traditional stock and bond ETFs, the fundís rigid legal structure doesnít allow it to issue new shares to meet investor demand. The Securities and Exchange Commission (SEC) must first approve any such move.

As you might have figured, time is running out for UNG. If the fundís management is unable to get the SECís approval to issue more shares, UNGís shares could begin trading at a premium to their underlying value. This would create a pricing discrepancy commonly seen with closed-end funds, but not typically experienced in the ETF market. Handkerchief anyone?

UNGís perplexing situation is reminiscent of what happened in the horror thriller Frankenstein.

Against the good advice of a colleague, Dr. Victor Frankenstein injects life into a dead corpse and thatís just about when his problems begin. Besides destroying poor Vicís science laboratory, the monster terrorizes the entire village and even kills a few people along the way. Has Victoria Bay Asset Management (UNGís manager) created a natural gas monster? 

Credit and Taxation Risk
Investors have short memories. And many have already forgotten about the fall of ex-Wall Street titans like Bear Stearns and Lehman Brothers.

In Lehmanís case, investors in its exchange-traded notes (ETNs) were left holding the bag. Instead of getting the wonderful returns they expected from their Lehman Opta notes, investors were forced to get in line with other duped creditors after the company was forced into bankruptcy. Can it happen again?

Today, Barclays Global Investors (BGI) offers the broadest menu of ETNs. The iPath Dow Jones-AIG Commodity Index Total Return ETN (NYSEArca: DJP) and the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEArca: OIL) have combined assets of almost $2 billion. I wonder how much of that money understands the acute credit risk they face. But never mind that, BlackRock has agreed to become BGIís new owner and everything is going to be OK. The status quo rules!

Taxation risk is another little discussed hurdle facing ETN investors. Todayís tax advantaged status of equity and commodity ETNs could go the way of the dodo bird at any moment. The IRS has already ruled against currency ETNs saying that any interest paid to investors is taxable even if itís reinvested and not paid out until the ETN holder makes a sale of their note.

The message is loud and clear for all investors: Itís a stupid financial trick to accept and tolerate unnecessary credit risk. How many more warnings will you ignore?

Wrong-way Bets
If there was anytime for Americaís mutual fund managers to be protecting the financial interests of their shareholders, now would be it. Instead, fund managers have subjected their clients to a broad spectrum of financial perversity. 

Look no further than the Oppenheimer Core Bond Fund (Nasdaq: OPIGX). For years the bond fund delivered steady returns and then 2008 happened. The fund dropped 40% in value compared to around a 5% gain for major bond benchmarks like the Barlcays Capital U.S. Aggregate Bond Index (NYSEArca: AGG). What went wrong?

Former manager of the Oppenheimer Core Bond Fund, Angelo Manioudakis backed up the truck on mortgage-backed securities. According to Morningstarís analysis, shareholders of OPIGX owned $1.80 worth of credit securities for every dollar they invested. Manioudakis was also the Chief Investment Officer for the institutional fixed income division at Oppenheimer Funds and he has an MBA from the Harvard Business School. The big titles and cute resume did little to help Oppenheimerís bond investors. 

Rest assured, we have havenít seen the last of stupid financial tricks. Some of these tricks come from unexpected sources too.

Institutions like the Federal Reserve and the SEC often fail to live up to their mission statements to create orderly markets and to protect the investing public. The latest promise to overhaul financial markets with sweeping new rules is around ten years too late, maybe twenty.

Wall Street is already cooking up more financial perversity in its never-ending pot of lousy ideas. No doubt, new fangled financial instruments and investment strategies will replace the old broken ones. How will you react? You can be a participant, a guinea pig, a victim or an observer. Which do you want to be? You decide.

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